How to Avoid the Financial Pitfalls of Confirmation Bias
The world is full of choices. They range from the mundane, like picking out what to have for dinner, to the significant, like whether to go ahead and buy your first home or keep saving for a larger down payment.
And with each choice comes a level of uncertainty about our decision. So what do we do when in doubt? We tend to look for reassurance—someone (or something) to tell us that we’re on the right track, that we made the correct choice.1
Sure, we love being told what we want to hear. But confirmation isn’t always in our best interest.
In early 1929, the Federal Reserve issued a statement warning investors of the dangers of stock market speculation.2 Nonetheless, some economic experts continued to sustain public optimism3—including Andrew W. Mellon, then-Secretary of the U.S. Treasury, who proclaimed shortly before the crash, “There is no cause to worry. The high tide of prosperity will continue.”
Their concerns assuaged, many investors continued funneling money into the stock market—with the Dow Jones Industrial Average swelling to a record high in early September—only to see the market collapse spectacularly within a month.
People who ignored the Federal Reserve’s warnings and embraced Mellon’s sunny outlook because it supported their beliefs were acting out a behavioral phenomenon known as confirmation bias.
Confirmation bias is when a person unconsciously favors information that supports his or her preexisting beliefs, while rejecting evidence that contradicts them. It can compel a person to construe ambiguous information—or even remember past events—in a way that supports his or her opinions.
Confirmation bias can encourage us to insulate ourselves from contradictory perspectives without realizing we’re doing so. Research has shown that people are more inclined to have friends with similar ideological views on social media platforms, resulting in the sharing and reading of news articles that align with those same viewpoints.4
This phenomenon doesn’t just apply to our perspective on the news, however. Investors who are active in virtual communities or on message boards can also be affected by confirmation bias.
One experiment used a popular stock message board in South Korea to test how the community influenced investors’ trading decisions and performance. Researchers found that investors who were most likely to seek out supporting peer opinions and ignore contradictory evidence were also the most likely to make mistakes that ultimately led to lower returns on their investments.5
Escaping the bubble
It’s a natural instinct to favor your existing beliefs—convictions have value, after all—so you can never completely root out confirmation bias. But there are ways to help minimize its impact on your financial well-being:
Play devil’s advocate: Force yourself to consider an alternate position. Before committing to a new investment, for example, seek out information that could change your mind. Is there anything you’ve been overlooking? Are there any potential changes in the business or markets that would make the investment less attractive?
Once you’ve made an investment decision, be sure to revisit it periodically to make sure it still fits your goals. Say you bought a significant amount of stock in XYZ Corp. more than a decade ago. The stock initially appreciated, but now it’s been steadily declining for years. You hold onto the stock because—despite market reports to the contrary—you believe that one day it will finally recover and be worth more than you paid for it. You talk to a trusted friend who actively trades, who says your prediction is spot-on. But is your friend only telling you what you want to hear? What advice would you give to another investor looking to purchase stock in XYZ Corp.? Would you buy the stock today, knowing that the odds of further decline are high?
Leave emotions out of it: Having a financial plan; building a diversified portfolio to fit your goals, time horizon and risk tolerance; and sticking to your plan through periodic rebalancing can all help emotions from intruding on your investing. Instead of relying on opinions—your own or your peers’—your asset allocation strategy can be your guide for what to sell and what to buy.
Use the right tools: Schwab clients enrolled in Schwab Trading Services can use the Gain/Loss Analyzer to accurately gauge their performance. It’s an unbiased way to track your trades’ success—and guard against conveniently forgetting the trades that haven’t gone your way. And the Portfolio Checkup tool, available to all Schwab clients, compares your holdings with your target allocation to let you know if you need to rebalance.
Seek an outside opinion: A good financial advisor will help you come up with a plan and provide guidance to help keep you on track. They’ll provide an informed opinion that’s guided by your goals and needs—not by what you want to hear.
1Roderick M. Kramer, “Rethinking Trust,” Harvard Business Review, June 2009.
2“Stock Market Crash of 1929,” federalreservehistory.org, November 2013.
3Eugene N. White, “The Stock Market Boom and Crash Revisited,” Journal of Economic Perspectives, Spring 1990.
4Eytan Bakshy, Solomon Messing, and Lada A. Adamic, “Exposure to Ideologically Diverse News and Opinion on Facebook,” Science, June 2015.
5JaeHong Park, et al., “Confirmation Bias, Overconfidence, and Investment Performance: Evidence from Stock Message Boards,” SSRN Electronic Journal, July 2010.