We all love to be right rather than wrong! As a result we seek out information that confirms that we are right and ignore information that could indicate we might be wrong. Confirmation bias is the natural human tendency to seek out information that tells us that we are on the right track, while avoiding any information that would indicate that we might be headed in the wrong direction.
In fact, recent studies have indicated that people are twice as likely to seek information that confirms what they already believe than consider evidence that contradicts those beliefs. Investors having a confirmation bias would reference only those perspectives that validate their pre-existing views, while ignoring or dismissing opinions or data, which are contrary to the existing view, however valid they might be.
For example, investors intending to buy a particular stock would only look for favourable news that would reinforce their beliefs that the investment is indeed an attractive one, while disregarding information that indicates that they should avoid the stock. Investors, who have a positive opinion on a company, might even misinterpret genuinely adverse news as favourable news. On the other hand, investors intending to sell a stock may disregard information that might suggest that they might be better off holding it.
Investors might go about justifying these actions on account of confirmation bias. This is one of the reasons why investors take a lot of time to realise that they have genuinely committed a mistake by buying or selling a particular stock.
Confirmation bias can lead to sub-optimal decisions both in terms of choice of investment decisions or the buy/sell timing of the chosen investments. For example: When an investor hears rumors that stock A is expected to double in 6 months or 1 year, they would only look for data or opinions which concur with the rumour that stock A is indeed a good buy and ignore any contrary opinions or data that indicates that they would be better off avoiding investment in stock A.
How to avoid falling prey to confirmation bias?
Investors can avoid confirmation bias by aggressively seeking out evidence that disagrees with their existing belief. By objectively evaluating the contrarian view, investors can avoid committing mistakes due to the confirmation bias. Investors could also consider alternate views from experts as part of their investment process. Investors should also consider various alternative investment decisions and know why they are choosing one investment decision over the other. Before making an investment, it is usually advisable to write down the reasons for making the investment, so that the investment decision can be evaluated based on the actual outcome, which would eventually improve the investment process. In other words, a structured investment process would help investors in avoiding confirmation bias.