Beware confirmation bias in investment decisions and in life

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Christian Peterson, CMT®    Investment Analyst
Christian Peterson, CMT®
Investment Analyst

“A lie can travel halfway around the world while the truth is still putting on its shoes.” Mark Twain

Mark Twain lived from 1835 to 1910 and the first transatlantic cable was completed in 1858, so even in Mark Twain’s day, a false rumor could travel pretty fast.  How much further, then, can a rumor travel these days, what with fiber optic cables, satellite TV and cell phones?

But this still begs the question of why rumors and lies travel faster than the truth.  Doesn’t the truth have access to the same communication channels as those rumors?  Yet we’ve all experienced situations in which false information, or a rumor, will get passed around (and believed) even though the truth of the matter was easily in reach if someone just took the time to look.

There are a couple of reasons for this.  First of all, the truth is usually boring, while the rumor will often be juicy and entertaining.  Second, the truth is usually complex, or nuanced.  Human beings and social organizations are complicated.  Who of us has ever met a perfect person, or worked in a perfect organization?  The truth, whatever it might be, will of necessity be a reflection of the imperfect situation from which it arose.  The rumor, or lie, will often be simple – or better yet, simplistic – easy to understand, easy to communicate and easy to relate to.

But there is another reason that rumors, or lies, travel faster than the truth and that is because rumors or lies travel on a glide path that is paved by our own preferences.  The science of Behavior Finance calls this “Confirmation bias”, the propensity to accept any piece of information that conforms with what we desire, and the rejection of information that does not.  This is a mistake that investors make all of the time.  As an example, consider Bob.  Bob is holding a stock that has lost money.  Bob likes the stock and would prefer to hold onto it rather than sell at a loss.  That being the case, Bob is likely to pay close attention to any news about the company which would indicate an upturn in its fortunes.  At the same time Bob will ignore, or discount, news that is unfavorable.  This could leave Bob in a situation where he holds onto the stock for longer than was prudent and force him to sell at an even greater loss.

Confirmation bias is dangerous because it works below the level of consciousness.  Having read this example, we might say to ourselves, “Now that I know, I won’t make the same mistake as Bob.”  Maybe we wouldn’t, but we could never know if we’ve eliminated all the biases we have in regard to a particular stock – or about stocks in general.  Because our mission is to move assets to safety when the market is falling as well as invest profitably when the market is rising, we in the investment department are trained to look at all sides of the market at all times.  Thus, we avoid the worst consequences of confirmation bias when it comes to investing.

Confirmation bias affects us in all the areas of our lives and all we can do is be vigilant and work to root out those that show themselves, humbly acknowledging that we’ll never get rid of all of them, (unless you’re one of those perfect persons I’ve never met in which case, please give me a call).