Consider the opposite when investing

Consider the opposite when investing
04 April 2013

Three of the most common behavior pitfalls discovered in behavioral finance research are confirmation bias, unrealistic optimism and overconfidence. Be honest; Do you think of yourself as a very good driver, better than the average? If you do, you are not alone. About 80% of the people who are asked this question will say yes. Evidently, we tend to overestimate our driving abilities. It is probable that the same thing is true when it comes to making investment decisions.

If you are overconfident, you are certainly not alone. Research psychologists Taylor and Brown indicate that: “... considerable research evidence suggests that overly positive self-evaluations, exaggerated perceptions of control or mastery, and unrealistic optimism are characteristics of normal human thought.”

Sub-optimal decisions

We have written a lot on cashy about rational and irrational behavior leading to sub-optimal decisions and judgments. When it comes to investment decisions I believe people show dysrational behavior, which is defined as the inability to think and behave rationally despite adequate intelligence.

So how do we overcome this dysrationalia when it comes to investment decisions? Of course it is good to be aware of our overconfidence and unrealistic optimism but we can improve our decisions and choices much better by awareness of the confirmation bias. This should enhance our ability to form rational beliefs and to take rational action.

The confirmation bias leads people to add more weight and relevance to information which confirms their views, and to underweight information which disconfirms those views. In fact people often seek out only information that confirms their views. People rarely challenge their own beliefs… we don’t give full consideration to the opposite view.

Effectively -- people are reluctant to search for evidence that contradicts their beliefs. And, even if they find such evidence, they treat it with excessive skepticism.

It’s not difficult to see how the confirmation bias can help us feel good about ourselves, whenever we have information that verifies our beliefs or previous assumptions our self esteem is boosted, our testosterone levels are higher and our optimism and confidence grows.  And this is when we can make mistakes. The financial crisis of 2007 and 2008 is littered with examples of individuals, banks, institutions and government agencies that used confirmation bias to justify their investment decisions and practices.

Look for views opposite to your own

The antidote to confirmation bias is to search for information that disconfirms our judgments or opinions, sometimes known as the Scientific Truth method.

Acting on information that disconfirms our initial assumptions is not easy; we tend to give more weight to good news than to bad news. In their paper, How Unrealistic Optimism Is Maintained in the Face of Reality, Tali Sharot and her collaborators find that when people receive information that is better than expected, they are likely to change their beliefs -- but when what they learn is worse than expected, their beliefs are more likely to remain constant.

You read that right, if you are thinking about investing in shares and you discover analyst’s strong buy recommendations based on a high probability of the stock going up you will have confirmation of your decision. But bizarrely when analysts are negative on the stock, and you have already made your mind up to invest, you are still likely to invest!  For those who are strongly fixed in their views, encountering counter arguments can cause them to strengthen their views.

Overcoming confirmation bias requires active, effortful research, otherwise known as motivated cognition (more ordinarily known as “rational decision making”), when investing, be it in shares, property, bonds or a business it requires that we remain objective until we have gathered all the facts and carefully considered them.

We change our minds less often than we think, yet sometimes to improve the truth of our beliefs or pre-conceived ideas we must change our decision process. This is hard to do because it calls on effort... and is there really any other way to earn money or a return on investments than doing the work? When we do the work, the rewards of well researched investing can be significant and fun too.

Always consider the opposite view before investing. Can you see examples when you have used confirmation bias to justify your investment decisions?

Comments

  • Colin
    Colin
    2013-05-22T12:18:19

    Carl Richards writing in his BehaviorGap column in the NY Times has an interesting article on confirmation bias and how to 'try' to overcome it, titled "Challenge what you think you know," and is well worth a read.

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