Confirmation Bias in Behavioral Finance

The vast majority of investors fail to perform well in the stock market because of behavioral and emotional reasons. The presence of financial knowledge or the lack of it does not make a huge difference. Instead, it is the behavioral biases that turn out to be the crucial deciding factor.

Hence, it is imperative for investors to actively search for biases that may be deep-rooted in their thinking philosophy, and they make attempts to weed them out. In this article, we will have a look at how confirmation bias works and how it impacts investment behavior.

What is Confirmation Bias?

Let us start by understanding what confirmation bias really is. Confirmation bias is the tendency of human beings to actively search for information that matches with the preconceived notion that they have. Individuals tend to pay an excessively large amount of attention to the information which confirms their beliefs. At the same time, they tend to discredit any information that does not conform to their belief.

It needs to be understood that the investor is not doing any of this consciously. Instead, the entire process takes place subconsciously. Investors tend to hold a belief which is often not the result of due diligence. The mind of the investor automatically seeks out information that helps confirm the belief while shunning away information that contradicts it. The problem with confirmation bias is that the investor feels as though they have done the required due diligence even though they really haven’t

Why Do Human Beings Have Confirmation Bias?

Human beings are always searching for inner harmony. This means that they want their beliefs to be harmonious. Hence, if any person is holding conflicting beliefs at any given point in time, it becomes their innate nature to choose one belief. Then they start choosing facts that support their beliefs. This is done by them subconsciously in order to avoid cognitive dissonance. Confirmation bias is a deep-rooted evolutionary behaviour that allows human beings to maintain their sanity.

How Confirmation Bias Affects Investment Behaviour?

Confirmation bias affects decisions in all walks of life. However, it has a profound effect when it comes to financial behavior. Some of the main distortions caused by confirmation bias have been listed below:

• Missed Opportunities: Confirmation bias is responsible for a large amount of missed opportunities. This is because investors are only able to identify an opportunity and invest in it if they are able to get a fair and unbiased view. However, investors who have a confirmation bias are actually preoccupied with their own thought processes. They do not tend to pay attention to the opportunities presented to them. This is because they are preoccupied with their own notions.

• Concentrated Portfolios: Probably, the worst outcome of confirmation bias is a concentrated portfolio. It is a known fact that over the course of time, diversification provides a shield to investors. Investors who have a diversified portfolio earn a better risk-adjusted return as compared to their peers. Confirmation bias causes the thinking of the investors to become distorted. They become obsessed with a few companies or a few investment classes. This causes them to ignore diversification and concentrate their holdings in a single company or investment class. This may benefit them in the short run. However, empirical evidence states that in the long run, diversified portfolios do much better than concentrated portfolios.

• Prone to Bubbles: Another problem with confirmation bias is that this thinking is prone to get the investors into asset bubbles. This is because, in the case of asset bubbles, the price of the asset keeps on going higher until one fine day, it doesn’t anymore. This means that people with confirmation bias are likely to invest more and more in asset bubbles as compared to other investors.

How To Avoid Confirmation Bias?

Avoiding confirmation bias can be tricky. However, it is possible. The trick once again is to first realize that there is the possibility that one’s thinking may be biased. Half the battle is one when an investor starts to doubt their thinking and acknowledges the possibility that he/she may be flawed. Some other steps that can be taken are as follows:

• Actively Seek Contradictory Evidence: In case of confirmation bias, the mind is working automatically to seek evidence in favor of a belief. Hence, if there is no external interference, the belief may get reinforced over time. The role of an investor is to play the devil’s advocate. They must always seek evidence to disprove the belief that they are holding. It could also be to prove an opposing belief. However, the idea is to hear both sides of the argument. If there is merit in the other argument, the investor will be forced to modify their behavior, and the bias will be avoided.

• Consider The Other Person’s Point of View: In some cases, the investor’s belief might be too entrenched. As a result, they may not be able to consider the other points. Hence, it would be better for them to ask another person to debate and provide an opposing view. There is always an opposing view because if there is a buyer, then there is also a seller. The existence of a seller proves that there is someone who has a difference of opinion. Understanding their stance can prove to be worthwhile.

The bottom line is that the confirmation bias can cause significant distortions in the thinking of the investor. These distortions can then also lead to serious financial consequences.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.