A 2009 study found people are twice as likely to seek information that confirms their beliefs than to seek evidence that discounts them. Peter Watson first proved this with his selection-task study in the 1960s.
As choices are guided by our thought process, it can be a very costly mistake. Especially when money is on the line. (Read our free special report The Bank of You and learn why you should invest in P2P loans in 2017.)Image source: The Blue Diamond Gallery
How Confirmation Bias Broke Gold Bulls in 2011
Under the spell of this bias, the more you learn, the more certain you become that you are right. We don’t know it at the time, but biased research paints an incomplete picture of the situation. A 2015 survey by the CFA Institute found confirmation bias commonly influenced investor judgment and led to poor investment choices.
At the end of October, the value investor Mohnish Pabrai gave a presentation and took part in a Q&A session at Boston College and Harvard Business School on the Uber Cannibal Investor Framework, which he has developed over the past decade. Uber Cannibals are the businesses “eating themselves by buying back their stock,” the value Read More
A look at the actions of gold-bulls over the past decade is a good example.
In the three years after the 2008 financial crisis, gold rose over 60%. Pointing to the economic and monetary follies of the period, gold bulls believed the yellow metal would continue to climb and invested accordingly.
Since its 2011 peak, gold has fallen by 35%. During its decline, bearish signs like a strong US Dollar were ignored. Instead, they focused on the reasons why gold had entered a new bull market. They later paid the price.
This bias has been observed in other investors. A 2010 study found that investors strongly preferred ideas that matched their own on internet stock message boards. When investors had a ‘’strong-buy’’ view of a stock, they were 8-times more likely to click on bullish posts about it.
The study concluded that the most biased investors became over confident in their beliefs due to confirmations. In the end, when an investor’s bias increased by 1 standard deviation, it led to excessive trading and decreased returns by over 9%.
With a myriad of online investment information, having biases is easier than ever. Whatever your views, you can connect with others who share them. This can lead to an echo-chamber like environment for investors.
When things are going well, there is no problem. But when investors hit a rough-patch, they may have no clue why their picks are tanking. Investors are likely to repeat this mistake time and time again.
If bias intrudes on our decision process, how can we manage the risks it poses?
Warren Buffet’s Approach to Decision Bias
It’s natural to look for evidence that confirms our beliefs, but we should actually be doing the exact opposite. To test a premise, we must subject it to contrary evidence and see if it stands or falls.
Warren Buffet, one of the most successful investors in history, knows this and proactively manages it.
For the 2013 Berkshire Hathaway annual general meeting, Buffet invited fund manager Doug Kass—a vocal critic of Buffet—to participate. Kass didn’t convince him to dump any of his stock, but Buffet knows he must expose his ideas to conflicting thoughts.
This may sound easy, but the fact that 99% of actively managed equity funds underperformed the market tells us it isn’t. An effective way to nullify decision bias is to create a disciplined investing system.
How to Create Your Own Investing System
Such a system must have strict, pre-defined guidelines that you don’t dare deviate from. Rules that detail the maximum loss you are willing to take on positions is essential. You can automate this by using stop-losses on your investments.
Having a specified exit-strategy is also crucial. Before you invest, write down a few points stating why you would sell or add to your position(s) in the future. This could mean taking action when the investment reaches a certain price or ratio.
Investors must also take a long-term view to investing and try not to get caught up in short-term moves. It’s easy to buy rising investments or sell falling ones to our portfolios in an instant. However, making quick trades is one of the reasons active investors underperform the market.
Another way to limit the damage bias can cause is by using a dollar cost averaging strategy. With this strategy, investors make small, regular investments instead of large one-offs. This limits potential downside risk and protects against the emotional roller-coaster that comes with holding large positions.
It’s important to invest in line with your personal risk tolerance. After all, the purpose of investing is to gain wealth. One cannot become wealthy if one is consumed with worry.
For investors, developing an objective strategy is essential in limiting the threat of confirmation bias. If you let this bias go unchecked, you risk undoing all the hard work you put into your investments.
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Article By Stephen McBride – Garret/Galland