Confirmation Bias Can Undermine Your Portfolio
by Peter Mallouk
If you want to be a successful investor for the long term, learn to seek out ideas that challenge your most basic assumptions.
Most people who get excited about investing dive into research, read market-timing or stock-pick letters, use on-line services, and watch financial news all the time. The idea is that the more they know, the better they will become, and the less likely they will be to make a mistake.
It doesn’t really work out this way. If you have a reasonable level of intelligence and you understand basic principles, you will likely outperform the vast majority of investors. The key is to not mess things up. Unfortunately, there are plenty of ways to do just that. Nothing I have personally seen causes more financial destruction than the emotionally driven mistakes investors make. The key is to recognize your behavioral biases so that you can knowingly protect yourself from making mistakes. Confirmation bias encourages the sorts of mistakes that can cause permanent damage to one’s portfolio.
Confirmation bias is the tendency for people to look for and favor information that confirms their preconceptions and beliefs, and to avoid, devalue or dismiss information that conflicts with their beliefs.
For example, a conservative may read The Wall Street Journal, view the Drudge Report on-line and watch FOX News, while a liberal may read The New York Times, view the Huffington Post on-line, and watch MSNBC. Both are seeking out information that usually confirms their ideas and avoiding information that may conflict with their ideas. When was the last time you subscribed to a magazine, bought a book, or regularly listened to or watched a political pundit that challenged your views? If you are like most people, it’s been a long time. In fact, you probably spend most of your time validating what you already think is right.
What if I asked you to write down your top 10 beliefs on hot political and religious topics. Think of things that, you know, tend to get people worked up: guns, abortion, fiscal policy, global warming, religious beliefs and so on. Now, do you think you are right about all 10 beliefs? If I brought to you the most prestigious and authoritative people in the world on each of the 10 topics to present their thoughts to you, do you think any of your thoughts or ideas would change? They likely wouldn’t. Instead, you would likely devalue or dismiss nearly everything they would have to say.
You see, we all think we are right—and not just about some important things, about everything! And we constantly seek ways to validate what we think. Highly intelligent people are doing just the opposite and instead actively seek out opposing sides of view, challenge their ideas, and even occasionally change their minds.
If you want to get better at controlling this powerful force called confirmation bias, you need to recognize the little devil inside of your brain constantly encouraging you to validate your preconceived ideas. If you can’t do that in life, well, maybe you can at least try to control confirmation bias when it comes to investing.
There is ample evidence that confirmation bias permeates throughout investors’ decisions. For example, once an investor likes a stock, he is likely to seek out information that validates the stock. In a 2010 study, researchers showed that investors used message boards to seek out information that validated, rather than challenged stocks they owned (Park et al., 2010). If we own a stock, we tend to look for anything that validates our decision to buy it, and to reinforce why we should keep holding it.
Even Warren Buffett said that he finds himself falling prey to confirmation bias and actively seeks out other investors who disagree staunchly with his ideas. One way to deal with confirmation bias is to ask yourself everything that could go wrong.
For example, if you really like the idea of investing in a specific investment, pretend 10 years have passed and that you have lost a substantial sum of money on it. Ask yourself all the ways that might have happened. This forces your brain to go through the exercise of acknowledging—or even, dare I say, welcoming adverse ideas.
You will be a better investor for it.
Peter Mallouk is president and chief investment officer for Creative Planning in Leawood, Kan.
P | 913.696.0500
E | mallouk@thinkingbeyond.com
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