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There are many dangers for individual investors to be aware of when investing. More and more of these dangers and/or complications are being recognized in the field of behavioral finance. Behavioral finance looks at the psychological and emotional factors that influence the decision-making process of investors. Oftentimes researchers in this field try to figure out what causes normally rational people to act irrationally. Unfortunately, it has proven over and over again that, when money is involved, the vast majority of people let their emotions/feelings interfere with their investment decision either slightly or in profound ways. We do these things without even knowing it which makes it even harder to address and correct. Keep in mind that Warren Buffett says that having control of one’s emotions is just as important (or even more so) than having a superior intellect that can select excellent, long-term investments.
Confirmation bias belongs in the realm of behavioral finance, but, as many of these issues, it really first has been examined in terms of psychology. So, what is confirmation bias exactly? The definition of confirmation bias is “the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses” (Plous, Scott (1993). The Psychology of Judgment and Decision Making. p. 233). Keeping in mind that confirmation bias applies to many other areas, the primary focus in the remainder of this article will be how it manifests itself in relation to investing. Now that we have the formal definition, let’s take a look deeper into this very real danger for individual investors.
Individual investors have the natural inclination to make a decision first and then look for information that supports that initial decision. It also applies at an even higher level than that. The way that individual investors think they should invest in general is almost predetermined. The easiest thing to do is to talk to people with the same thought process about investing, search through the same supporting financial media news publications and websites, and listen to the same experts. Over time, it gets very easy to just keep doing the same thing over and over again. Plus, it takes an incredible amount of effort to step outside of one’s comfort zone and try to prove that he/she might in fact be incorrect. Individual investors (and even professional investors, money managers and investment advisors) are not wired to attempt to confirm why they might be wrong. At first glance, it seems like a totally foreign and nonsensical concept.
So, what are the types of problems that can occur when individual investor does not acknowledge confirmation bias? There is a long list here are a few to ponder. First, a big mistake can be thinking that what has happened in the recent past will continue into the future indefinitely. This danger is especially evident during a bull market. It can be easy to get carried away and see how much money one made and then keep pouring money in (more than you can really risk). The converse is true when it comes to a bear market. After stocks have gone down for a number of months or longer, it is very easy to just give up on investing in the stock market because it seems like things will never turn around. Second, the danger creeps in when investing by not challenging one’s assumptions. Even if an individual investor knows at a subconscious level that an incorrect decision was made, there can be a desperate search for any shred of evidence that one can justify nonaction. Third, there are times when listening to the investment advice of a particular expert can be “addictive”. By this I mean that it is natural to continue to listen only to the views of that person, especially when he/she made a bold prediction about the stock market that came true. It can be simple to forget that market timing is extremely difficult and that person could be totally wrong in terms of his/her next prediction. Lastly, it can feel good to be part of the crowd and not think differently (or at least examine other issues). There is safety in numbers essentially and, if your investment decision does turn out to be wrong, you can at a minimum take solace in the fact that “everyone else was doing it”.
There are a number of steps that individual investors can take to counteract the dangers of confirmation bias. First and foremost, the fact that you are aware of the potential trap of confirmation bias is half the battle. Periodically ask yourself if you have looked for alternative viewpoints and evidence. Second, you can make a list of why you made a particular investment decision in the first place. But, more importantly, you should write down what types of events could occur to make you change your mind because your investment thesis was not correct. It is very powerful to have a written record to start with. This recommendation actually comes from a reporter at The Wall Street Journal named Jason Zweig. Mr. Zweig has been writing about the financial markets for decades now and still has a weekly article in the paper (usually in the weekend edition) called The Intelligent Investor. I really urge you to take a look at this interview with him back in 2009 about confirmation bias. Here is the link:
Third, you should make it a habit on a regular basis, maybe monthly, to go to various financial market and investing websites that do not mesh with your general investment philosophy. You can peruse through a few articles that you might find totally different than you interpret a situation. I urge you to read them with an open mind though and try to be objective. Lastly, you can bounce an idea off a close friend or advisor and see what they think about your rationale. It is far easier for them to be objective. If you do not have anyone to consult with, I would urge you to pose the question in an investing forum. However, you need to phrase the question in the manner that will address your possible confirmation bias. It is very common to ask question in a positive manner like “Why should you invest in technology companies?”. The better way to phrase it at the outset is to use language like “What are some of the reasons why you should not buy gold?”.
Now keep in mind that the advice on confirmation bias also applies to the articles I have posted on my website. You will note that two of the main themes are using a passive investing approach to invest and striving to keep investment fees as low as possible. I urge you to go and seek out information about why you may want to choose an active investing strategy as an individual investor. Look for the reasons why and situations where you might have to pay additional investment fees depending on your particular circumstances. It is very healthy and beneficial to seek out other information, and I always encourage individual investors to do so. The one thing that I firmly hold onto is that I would avoid financial websites or sources that say I am right and the other guys are all wrong. Things are rarely ever so “black and white”, especially in the world of financial markets and investing.