Mirror, Mirror on the Wall: How Avoiding Confirmation Bias Will Improve Your Portfolio

Mirror, Mirror on the Wall: How Avoiding Confirmation Bias Will Improve Your Portfolio

Knowledge is power, right? That’s what we’ve been taught.

Recent psychological research, however, calls this fundamental premise into doubt, raising the question of whether ignorance–or, at the very least, more limited exposure to information–may in fact bring us closer to financial bliss.

What Is Confirmation Bias?

According to psychologists, a natural phenomenon known as confirmation bias contaminates our decision-making process. Confirmation bias refers to the mind’s tendency to absorb facts that we agree with, and block out information that challenges our existing beliefs. Confirmation bias is the poisoned apple of decision-making, with the ability to undermine rational assessment.

For example, say you’re listening to CNN discuss certain facts about the U.S. economy. According to a recent analysis, you’re statistically twice as likely to choose to learn more about the facts that conform to your existing beliefs. (And if we’re talking about moral or political issues, people choose “congenial” information about 70% of the time!)

It’s as if our brains are rooting for us, inherently wanting to support the decisions we’ve already made. Like the wicked queen of the Snow White story, our subconscious looks to the magic mirror searching for validation, wanting us to be the fairest (and rightest!) in the land. We pay the price for this, and there’s the rub: If we’re not careful, our minds prevent us from seeing what’s actually there. 

Confirmation Bias and Investing

This tendency can affect our success, especially when it comes to investments. For every reason to buy an investment, there’s always an opposing reason to sell it. When we only listen to what we want to hear, we’re like a financial echo chamber.

After we invest, the problem is more acute. We tend to stick with our decisions longer, holding out rather than selling when the price keeps dropping, leading us to lose money.

Confirmation bias affects professional investors, too. In a recent experiment in South Korea, studies showed that investors who participate in virtual communities have poorer investment performances because they exhibit confirmation bias when they’re processing the information on stock message boards. This leads to overconfidence, higher expectations about performance, and lower realized returns.

How to Overcome Confirmation Bias

Luckily, confirmation bias is easy to sidestep once we’re aware of it. Here are several steps you can take to clear the cobwebs that may be clouding your decisions.

  • Create a fixed mix. When you begin investing, divide your money between investing categories (like small cap, large cap and international stocks). Decide what percentage you want to allocate to which investments, then try to keep those ratios constant by adding a fixed amount systematically every month. This removes part of the decision-making process along the way, helping you avoid confirmation bias.
  • Maintain a fake portfolio. Some investors and investors-to-be maintain mock stock portfolios, so they can see how good their investing sense is without putting money on the line. This basically amounts to tracking hypothetical investments you would buy. This can be as simple as writing down your picks or as high-tech as using a website that lets people maintain imaginary portfolios, like these. Mock investing may help you bypass confirmation bias because you're analyzing things on your own rather than worrying if you've made good choices. If you already invest for real, compare your fake portfolio with the true one, and examine any differences. Do you see any areas of flawed decision-making?
  • Before you buy something, assess its likelihood of failure. Write down what changes in the market would prompt you to sell. For example, say you owned shares of an international stock mutual fund that invests in many Chinese banks. If you heard that the Chinese banking system was on the verge of collapse, you might sell in the face of that. In addition, write down the likelihood that the investment will fail--although you obviously can't know this in advance, some investments are inherently riskier than others, so it's important to remind yourself how much risk you're prepared to take on with each. If you write it down now, it's a lot harder to lie to yourself later when you want to believe you were right.
  • Pretend your investment went bust. Then, come up with a list of all of the reasons this happened. For example, mutual funds typically don't go bust, but their constituent holdings certainly can. If you owned a mutual fund heavily invested in U.S. banks in 2007-2008, its value would have plummeted when some banks went bust. This mental exercise helps you gain a more accurate picture of potential flaws in your investing strategy. (In this example: Were you too heavily invested in financial stocks?)

By getting around the human instinct to selectively hear things you want to hear, you can confront prior decisions to figure out whether you made those based on true decision-making or whether they were influenced by confirmation bias. Doing this will also set you up for smart decision-making in the future, contributing directly to your portfolio’s increased growth and success.

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