Fundamentals of behavioral finance: Confirmation bias
Confirmation bias is the tendency to seek information that supports a person’s beliefs.
This bias may lead investors to focus only on information that reinforces their opinions about an investment.
Selectively choosing which information to use can lead to a lack of diversification and investments that are too risky.
Good communication between advisors and their clients can help combat confirmation bias.
Shifting a client’s focus away from short-term market moves and toward their long-term goals may help avoid the fallout from the confirmation bias.
What is confirmation bias?
Confirmation bias is a tendency to seek information that supports what we already believe and ignore information that contradicts these beliefs.
Confirmation bias operates in many areas of our lives. It's visible in news junkies who consume only media that supports their world view, and in pessimists who focus on the negatives while ignoring the positives.
In the investing world, confirmation bias may lead people to cling to preconceived notions about their investments, while discounting information that contradicts these ideas. For example, a client whose holdings are concentrated in a specific sector or group of stocks may only absorb good news and ignore bad news regarding these investments.
The BeFi Barometer 2021 study, conducted by Cerulli Associates and sponsored by Schwab Asset Management in collaboration with the Investments & Wealth Institute, found that advisors saw confirmation bias as one of the top behavioral biases affecting their clients’ investment decisions.1
Why does it matter?
Confirmation bias may lead to clients overinvesting in a particular stock or sector. For example, a client who is committed to owning shares of a particular company may ignore unfavorable news about that company.
Focusing too narrowly on a particular type of investment makes clients vulnerable to company- or sector-specific downturns, which in turn can leave their portfolios misaligned with their long-term goals and risk profiles.
Confirmation bias can also keep clients from realistically viewing market conditions. For instance, they may focus on some expert opinions while ignoring others. This can potentially lead investors to make decisions based on incomplete information.
What can you do about it?
Combatting confirmation bias requires open and effective communication. Start by querying clients about their long-held investment opinions, so that you can understand their perspective thoroughly. Then, gather an array of viewpoints and present clients with information that provides alternative points of view or adds nuances to their long-held investment beliefs.
Set up systems to help override clients’ cognitive impulses around investing. This may include creating objective trading rules around when clients can buy, sell, and rebalance their holdings. Such strategies can help them avoid making sudden investment decisions driven by their confirmation bias.
It can also help to remind clients to take a long-term view of their investments using a goals-based portfolio-construction process. Shifting their focus toward their goals and away from their individual investments can help them more easily embrace proper diversification.
Overcoming a client’s confirmation bias doesn't just lead to potentially better outcomes for your clients. Since it requires that you and your clients work closely together, it's an opportunity to strengthen relationships and improve retention over the long term.
Omar Aguilar, Ph.D.
Managing Director, Chief Investment Officer, Head of Investments