“Investing in the stock market is too risky." How many times have you been told the story of Uncle Robert who lost everything on a foolish stock market bet? Subconsciously, your research on the subject only tends to confirm this hypothesis; you will never take the plunge. Confirmation bias prevents you from thinking rationally about the stock market and admitting that, over the long term and with a diversified portfolio, it is probably your best source of return.
Confirmation bias is the tendency of humans to seek out, interpret, and record information that confirms their preconceived ideas and beliefs. This natural inclination strengthens self-esteem and decreases stress by avoiding contradictions.
The first manifestation of confirmation bias concerns information seeking: it is called "selective collection of evidence", a way for individuals to systematically search for evidence consistent with their basic hypothesis.
Stanford University conducted a significant experiment in 1979, with people with very strong opinions about the death penalty, half for and half against. Each of the groups had to read descriptions of two fictional studies showing either a positive or a negative impact of the death penalty on the crime rate in the United States. Almost none of the subjects in the study changed their minds after reading the prosecution or defense documents, pointing out flaws in arguments that conflicted with their opinions or accepting only arguments that supported them.
Our past experiences obviously influence our current judgment and behavior. But most people have selective recollection, this selectivity allowing them to confirm their current beliefs. In other words, we remember the past in a way that reinforces the present.
Confirmation bias can explain a substantial part of societal divisions and the difficulties of political leaders in reaching consensus, each stubbornly going in one direction and tending to favor information that confirms their point of view. Moreover, the development of social networks only amplifies the effects of confirmation bias, these sites using algorithms that predict what users want to see and effectively showing them only filtered information.
By considering different investment options, investors may subconsciously favor information that supports their point of view about an asset or strategy and underestimate the weight of data that could alter that point of view. Say you receive unreliable information about a company's strong potential for returns. Naturally, you'll focus your information search on what will turn the signals green, and you might miss out on a significant loss of customers, for example. Confirmation bias can thus create, in combination with herd effect, bullish or bearish trends that end up reinforcing themselves, regardless of economic fundamentals.
Confirmation bias also encourages investors to stay in their comfort zone without questioning their prejudices. As a result, they can easily miss new opportunities, clinging to principles such as "never dip into your capital" or "never get into debt" when market circumstances indicate that one should do so.
Confirmation bias can cause investors to focus on certain types of investments or businesses, thereby ignoring the sacred principle of diversification and increasing the risk of their portfolio. On the other hand, passive investing allows you to decorrelate your investment decisions from any parameter other than diversification. With the investment formulas in ETFs offered by easyvest, you avoid committing errors of judgment that Warren Buffet is not even immune to, despite being considered one of the best investors in the world!
Note: This article was written when Easyvest was authorized and regulated by the FSMA as an agent in banking and investment services.