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What is Confirmation Bias? Why is it Dangerous for Individual Investors?

26 Wednesday Apr 2017

Posted by wmosconi in active versus passive debate, behavioral finance, confirmation bias, Emotional Intelligence, EQ, finance, finance theory, financial advice, financial markets, Financial Media, Financial News, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, passive investing, personal finance, stock market, stocks

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behavioral finance, confirmation bias, Emotional Intelligence, financial advice, financial markets, financial planning, individual investors, investing, investing advice, investing information, investing tips, investments, stock market, stocks

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:

http://www.wsj.com/video/when-investing-consider-your-confirmation-bias/B768E62A-AA01-4B37-905F-F3EDA5C72B78.html

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.

Two Steps to Help Individual Investors Become More Successful at Investing

11 Thursday Jun 2015

Posted by wmosconi in Consumer Finance, Emotional Intelligence, EQ, finance, financial advice, financial markets, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investment advice, investments, personal finance

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consumer finance, Emotional Intelligence, EQ, finance, financial advice, financial markets, financial planning, individual investing, individual investors, investing, investing information, investment advice, investments, investors, personal finance

Navigating the complicated world of investing can seem very intimidating and so frustrating.  There are so many pieces of information coming from the financial media that seem to conflict with each other.  At times it seems as though the markets move up or down for no apparent reason.  What is an investor to do?  Well, one of the most important things to do is to work on your emotional intelligence (EQ).  Most people assume that you need to have an extremely high IQ to navigate the financial markets.  Now it doesn’t hurt to have a lot of intelligence, but it arguably more imperative to have a high EQ.  EQ, in its simplest terms as it relates to investing, is the ability to control one’s emotions during market volatility.  Extreme market moves either up or down tend to make investors act irrationally or in a panicked way.  Instead of the old saying of “buy low and sell high”, they do the exact opposite and “sell low and buy high”.  Therefore, I wanted to share two steps to help you utilize and develop your EQ to allow you to be a more successful investor.  You will note that the two steps are more akin to practices and definitely interrelated.

Step 1 – Learn how to ignore the “noise” about the financial markets on a daily, weekly, and even monthly basis at times.

What does “noise” mean in this context?  “Noise” relates to all the reporting by the financial media and market prognosticators about the short-term direction of the financial markets.  Every day you will hear market “experts” (money managers, economists, traders, CEOs, etc.) predict with a good deal of confidence that the markets will start to rise, start to fall, or stay unchanged.  How do these discussions with plenty of evidence and thought help you?  Well, every investor (even a novice) should notice something right away.  You know that these are the only three outcomes for the market to begin with.  It really does not help to hear the conflicting opinions on a daily basis.  Note that each day at least someone is saying one of the three outcomes for the financial markets.

Who should you believe?  What should you believe?  Now here is an important note about guest appearances that have had recent accurate predictions about the direction of the stock market.  The financial news networks will rarely bring on a guest that has been totally wrong and advised clients quite poorly in the recent past.  It is not advisable for either party to make the guest look bad.  What is the point here?  There is a bias when listening to a guest appearing on a news network because only the ones whose predictions came to fruition are brought back and asked for more ideas.  The moderator never points out the times when that same guest has been wrong in the past.  Thus, it can seem like every returning guest has the best possible advice to follow as it relates to investing.  Moreover, you should adjust your portfolio as he/she suggests.  Do not get caught in that trap!

The main point and reason for step one is that the sources for investing tend to be conflicting and seeming as though the individual investor must act right now.  There are actually very few times when the financial markets reach a point of inflection that truly warrants your attention.  For example, the October 1987 stock market crash, the 1994 bond crisis, the Asian contagion in 1997-1998, the Dot Com Bubble in the 1990’s that started to burst in April 2000, and the financial crisis of 2008-2009 most recently are events that individual investors should read about and learn what is happening.  Although I will though that the difficult part is knowing in real-time what these events are.  Hindsight is always 20/20 as they say.

For additional information, I strongly recommend that you read a blog post I posted a while back.  The discussion goes into far greater detail on this subject and will help you understand the nuances far better.  The link to this blog post is as follows:

https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/

After all the discussion above, what is the practice investors should develop?  Well, as difficult as it might be and foreign, I encourage/implore you to stop listening to financial news networks and reading financial newspapers (or Internet columns) on a daily or weekly basis.  Why?  Just as a simple truism, it is the easiest way not to succumb to the financial “noise”.  If you are not exposed to it, you will not act (or feel as though you have to act) on a regular basis.  I promise that as you use this technique you will become much more comfortable.  Your EQ will really start to develop and become more mature.  Now I am not recommending that you give up all together on the financial media and sources of information.  Individual investors should simply consult them less often.  Looking at summaries of monthly activity will give you a much more complete picture of what is going on in the financial markets.

Step 2 – Commit to Examining Your Brokerage Account Statements on a Quarterly Basis Only.

I will admit that this practice, and change in behavior, is the hardest for individual investors.  However, effective adherence to step one is only possible by following this recommendation.  Many individual investors look at their account balances on a weekly or even daily basis.  The financial markets can move up and down quite frequently in the short term.  If you constantly look at your portfolio, your EQ will be hard to control or even melt away.

The vast majority of individual investors have a long-term financial plan.  You should have determined your risk tolerance (how much market volatility you are comfortable with), set up an investment portfolio with exposure to different asset classes like stocks and bonds, and determined what financial goals you have for the future already.  By definition the plan is long term and should not be altered all the time.   Note that you will utilize your IQ to establish your investment portfolio and then harness your EQ to stick with it through the inevitable “bumps” in the road.  If you are only exposed to your account balance four times per year, you will be far more likely to make more rational decisions.  Investing is very emotional due to the fact that money is involved.  That is true and will never change.  With that being said, individual investors will have less chances to be affected by emotions using this practice; only four times per year.

What should an individual investor do each quarter?  The quarterly brokerage account statements should be examined every March, June, September, and December.  Take a look at the account balance as a whole and then how the different components of your investment portfolio performed.  Then open up the other two brokerage account statements in the quarter to simply see what the account balances were.  For example, if it was the first quarter, you would be opening January and February after you looked at March.  Now the important thing to remember is that only your terminal balance matters.  What does that mean?  It is merely a fancy way of saying that only the amount of money you have at the end of the quarter is important.  The manner in which your brokerage account balance got to be at the end of the quarter might be interesting to look at, but, at the end of the day, it does not mean much at all.  It is in the past.

These two steps will definitely assist you in becoming a more successful investor.  Note that I did not say a trader or speculator.  Investors by definition have a long-term orientation.  Traders and speculators deal in hours, days, weeks, or even minutes.  Individual investors should be focused on quarters, years, and even longer increments if a solid and well thought out financial plan is in place.

The decision and ways to reallocate one’s investment portfolio is a separate issue.  Over the course of time, it will become necessary to alter the exposure of an investor’s investment portfolio to different asset classes, sectors, or regions.  Those decisions involve the IQ again but having a well formed EQ will assist greatly in that exercise.  I will take a detailed look at account rebalancing in the next series of blog posts.

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