What Blinds Investors?
We want events to happen in our favor, we want the wind to blow with us, not against us. But the reality is different, do we understand this?
Our mind is deeply correlated with our emotions. It triggers us to fall into a well-established set of anomalies. This ambiguous correlation does dictate our way we make decisions.
Because we want circumstances to move in our favor, we seek shreds of evidence that confirm this tendency, avoiding what might disturb it.
It comes from our fear of the unknown, of the unpleasant. Yet, putting our head inside the sand as an ostrich does, will not alter reality in our favor.
What is it that I am referring to?
It is a bias, a behavioral bias, a very common one in the business world, and especially common in stock markets. It is called the Confirmation bias.
Confirmation bias is the tendency to select the information that reaffirms our past choices, beliefs, values or desires, and discount information that contradicts them. In other words, we prefer information that supports our position.
Confirmation bias becomes stronger when emotions are involved and it contradicts the rational decision-making process that assumes humans gather information objectively. Because based on confirmation bias, we gather information selectively.
You Would Fall into Confirmation Bias when …
- You advocate information that confirms your preconceived views
- You are critical and skeptical of information that challenges your views
- You avoid undertaking tests that you think may contradict your beliefs
- You tend to seek sources to tell you what we want to hear
- You interpret the information you receive in a way that is biased to favor your beliefs
- You give too much weight to supporting information and too little to contradictory
- You believe you have good information and strongly believe in your opinions
Life Examples of Confirmation Bias
In his book, Research in Psychology: Methods and Designs, Goodwin illustrates how we exhibit confirmation bias in our ordinary life. He states that people who believe in Extrasensory perception ESP, or in other words, the sixth sense, tend to keep close track of events when they were, for example, “thinking of Mom, and then the phone rings, it’s her!”.
On the other hand, they tend to ignore the times, which happen much more frequently, when “they were thinking of Mom, and she did not call. Or when they were not thinking of Mom, and she called”.
The confirmation bias is like a giant tree that can spread its root in all directions. This manifestation can easily happen in any event of our life, affecting the quality of how we make decisions.
For example, a research study on 502 investors reacting to stock market news, reveals that investors with confirmation bias select information that confirms their predictions, adding a little overconfidence, they end up exhibiting high expectations on their investment performance, yet, realizing lower returns.
Another study shows that pessimistic investors tend to under-react to good news and overreact to bad news, whereas optimistic investors are too focused on the good news that comes just after the bad news.
A mind is a terrible thing to change … you believe stocks are going to outperform other assets, and all you can hear are warnings of the bloodbath to come in the bond and commodity markets. In short, your own mind acts like a compulsive yes man who echoes whatever you want to believe.
– Jason Zweig, Wall Street Journal, November 19, 2009
Such biased behavior blinds investors from making rational decisions, as they interpret signals in a way consistent with their prior beliefs.