The problem of Confirmation Bias in making investment decisions

Numerous human cognitive or psychological biases make us take decisions that we later tend to regret. Sometimes the decision can be so disastrous that one might lose millions of dollars due to it. No matter how successful they are, every investor suffers from cognitive biases, especially confirmation bias. 

What is a confirmation bias?

Confirmation bias is the tendency of people to seek or emphasize information that confirms their belief or an existing conclusion or hypothesis while ignoring the information that contradicts it. This type of bias is widely explored in behavioural finance. 

Overcoming the confirmation bias that leads to poor decisions and investment mistakes can be difficult for investors. It limits their ability to make purely rational investment decisions.

Consequences of Cognitive bias in decision-making:

• Taking shortcuts
• Oversimplifying complex decisions 
• Being overconfident in the decision-making process.
  

Investors become overconfident because they keep getting data that more or less confirms the decisions they have made. This overconfidence causes a false sense that nothing will bite the dust, thus increasing their risk of being blindsided when something actually goes wrong.

Out of all the biases, we are more prone to confirmation bias because our brains are hard-wired to understand confirming data, mainly when the disconfirming data is negatively framed. For example, which one is easier to comprehend? “Forbes magazine is the best magazine” versus “Apart from Forbes Magazine, all other magazines are shit.” First one, right?

Both professionals and individual investors spend a lot of time looking for strategies that work or evidence that support their existing investment philosophy. While it is absolutely right to review evidence supporting your investment philosophy, a good amount of efforts should be put to search for evidence that negates or conflicts with your philosophy. This is called the “good evidence-based investment” approach.

How to minimise the risk of confirmation bias?

• Challenge the status quo and look for information that contradicts your investment thesis
• Invert the investment case to analyse why you could be wrong
• Revisit your investment case multiple times and challenge your assumptions. 
• Ask yourself why you are wrong rather than why you are right. 

Carl Jacobi, a famous 19th-century mathematician, said: “Invert, always invert.” Seeing all sides of a problem is critical to overcoming confirmation biases. It is essential to keep an open mind because evidence tends to cut in multiple directions, and understanding all perspectives reduces the chances of error.

The easier it is to make confirmation biases, the more difficult it is actually to understand them. If investors make efforts to understand their biases, they can highly lower their risk and improve their investment returns over time. 

For more extensive analysis and Market Intelligence reports feel free to approach us or visit our website: Venture Capital Market Intelligence Reports | VCBay.

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