Confirmation Bias

We have seen that one reason why investors think it is easy to beat the market is that they don't recognize that both skill and luck play a role in investor performance. Another reason that investors believe they can beat the market is that they ignore evidence to the contrary. This issue is not limited to when we are dealing with investments but is a persistent mental model we access all the time. Simply put, “The confirmation bias is the tendency to seek information that confirms prior conclusions and to ignore evidence to the contrary.”

Confirmation bias is a persistent feature of the financial markets. All underperforming fund managers will point to the performance figures that put themselves in the best light. This is the case with

individual investors as well. Earlier we discussed the necessity of keeping accurate records when tracking our own investment performance. This is important because as Meir Statman writes: “Investors who believe they can pick winning stocks are regularly oblivious to their losing record, recording wins as evidence confirming their stock-picking skills but neglecting to record losses as disconfirming evidence.”

 When it comes to our own skills, we are more than happy to delude ourselves by ignoring the hard truths.

It's not hard to see how our desire to focus on information that confirms our already existing beliefs could be a liability when it comes to investing. The fact is that even the very best investors are wrong a lot of the time. In a previous chapter, we saw that it is possible to be wrong most of the time but still be a profitable trader. Successful investors recognize that it is not a sin to be wrong, but it is a sin to stay wrong. Every trader will tell you that cutting your losses is the key to surviving in the markets. It doesn't matter why you are wrong, but recognizing you are wrong will save you from portfolio-killing events such as riding a favorite stock all the way down into bankruptcy.

The question is why are we stuck with this mental model that makes us so willing to overlook a broader reality. Michael Mauboussin notes how confirmation bias is really all about keeping the external world consistent with our own version of the world.

 Constantly questioning every idea we hold with new data and information would not only be time consuming but also exhausting. Confirmation bias allows us to stop thinking about an issue and relieves us from the need to act or react. We humans simply don't have enough mental bandwidth to be constantly testing our core beliefs.

Not only is confirmation bias a flaw in the way we process information; it is also present in the way we take in information. With confirmation bias at work, we perceive information in a selective fashion. On one level, we make conscious decisions on what information to take in: we watch Fox News or MSNBC; we read the Wall Street Journal or the New York Times. On a subconscious level, we simply never perceive information that may not fit with our worldview. While the selective intake of information is dangerous enough, our increasingly electronic search for information can lead us astray.

With so much of information coming from online sources, we need to be aware of the ways that confirmation bias can happen without any action on our part. Eli Pariser in The Filter Bubble highlights the many ways in which online information providers tailor the things we see based on some profile they have of us. In some ways, this predictive search can be helpful. When we search for a pizza place, it is helpful to know where we are so as to generate geographically relevant results. The ultimate goal of this online profiling isn't necessarily to best inform us; rather it is designed to get us to click or interact with the site in question. As Pariser writes: “The filter bubble tends to dramatically amplify confirmation bias — in a way it's designed to. Consuming information that conforms to our ideas of the world is easy and pleasurable; consuming information that challenges us to think in new ways or question our assumptions is frustrating and difficult.”

Given all the internal and external forces working against us as investors, it is imperative that we work to try and offset the effects of confirmation bias. In a sense, we need to constantly be asking, “Tell me something I don't already know” — because there is a good chance the markets already know it. There are three ways in which we can try and work against confirmation bias.

The first is to be conscious of the risks of the filter bubble. Personalization on the Internet is a feature and not a bug. Pariser notes the best thing we can do is try to get outside our comfort zone and visit sites that stretch our thinking. A conscious effort to expand our influences can go a long way in opening up different ways of thinking.

Second, we need to actively search out discomfiting evidence. If we have a strong belief about a company, we need to consciously seek out evidence that is at odds with our view. This is admittedly hard work, but it is a necessary antidote to confirmation bias.

The third way is to expose our ideas to others. On the face of it, confirmation bias shouldn't exist. It is not a helpful adaptation. However, the argumentative theory posits that we have confirmation bias because it makes us more effective advocates for a position. That is why the first two remedies we recommend to combat confirmation bias may be of limited use. Hugo Mercier states: “On the other hand, when people are able to discuss their ideas with other people

 who disagree with them, then the confirmation biases of the different participants will balance each other out, and the group will be able to focus on the best solution. Thus, reasoning works much better in groups.”

We humans are beset with all types of biases, some that are helpful, some that are benign, and some, like the confirmation bias, that can be harmful at times. The best investors recognize that they are likely to be wrong on a pretty frequent basis and take steps to minimize the harm that comes when errors occur. The worst situation for investors to be in is to be wrong and not have the tools to turn their thinking around.

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