Confirmation Bias

This week we are going to take a look at what is called Confirmation Bias. According to an article in Psychology Today by Shahram Heshmat Ph.D., “Confirmation bias occurs from the direct influence of desire on beliefs. When people would like a certain idea/concept to be true, they end up believing it to be true. They are motivated by wishful thinking. This error leads the individual to stop gathering information when the evidence gathered so far confirms the views (prejudices) one would like to be true.”

According to Michael M. Pompian, author of Behavioral Finance and Wealth Management “the effects of confirmation bias can be observed almost daily. Investors often fail to acknowledge anything negative about investments they've just made, even when substantial evidence begins to argue against these investments.” Pompian goes on to identify 4 behaviors that can cause investment mistakes.

1. Confirmation bias can cause investors to seek out only information that confirms their beliefs about an investment that they have made and to not seek out information that may contradict their beliefs. This behavior can leave investors in the dark regarding, for example, the imminent decline of a stock.
2. When investors believe strongly in predetermined “screens,” such as stocks breaking through a 52-week price high, confirmation bias is usually at work. These investors only use information that confirms their beliefs. They may blind themselves to information that demonstrates that a stock breaking through its 52-week high may not make a good investment.
3. Confirmation bias can cause employees to overconcentrate in company stock. As IBM and other examples demonstrate, intraoffice buzz about a company's prospects does not justify indiscriminate reliance by employees on company stock. People naturally tend to unduly emphasize evidence suggesting that the companies they work for will do well.
4. Confirmation bias can cause investors to continue to hold underdiversified portfolios. Many practitioners have seen clients become infatuated with certain stocks—not always the stocks of employer corporations. Over the course of years, such a client might accrue a large position that ultimately produces a lopsided portfolio. These clients do not want to hear anything negative about favored investments but rather seek, single-mindedly, confirmation that the position will pay off.

Don’t let wishful thinking guide your investment decisions, call us today and let’s discuss a realistic investment strategy.