- Money Morning Australia

How Confirmation Bias Could Ruin You


Written on 24 April 2013 by John Stepek

How Confirmation Bias Could Ruin You

I enjoy using Twitter.

For those who aren’t aware, Twitter is a website that lets you broadcast your thoughts to the world in 140 characters. More importantly, it lets you follow other people who might be saying interesting things, or linking to interesting articles.

It’s great for keeping abreast of breaking news, and sending messages to other users.

But can it make you a better investor?

Can Twitter Make You Money?

The FT’s Gillian Tett recently took a look at the results of a new study from Massachusetts Institute of Technology. Academics Sandy Pentland and Yaniv Altusher looked at how social media (such as Twitter) affects investment performance.

The researchers looked at the ‘eToro’ trading platform. This allows traders not only to chat about markets, but also to watch each others’ trades, and even copy them, if they wish.

The upshot of the study was that the best investors were those who ‘received information from a wide range of social groups — and copied a range of gurus — performed 10% better than ‘normal’ traders.’ They also did better than ‘traders following one or two gurus.

In short: ‘maintaining diverse social ties — and swapping information with several different crowds — tends to raise returns.

So should even the most technophobic investor be rushing out to sign up to Twitter and Facebook?

Of course not. Investors should be very picky about the information they consume. If anything, most of us should be consuming less news and information. It’s all too easy to be tempted to over-trade when you’ve got headlines screaming at you from every direction.

The Real Lesson from Social Media

However, the study does highlight a key psychological threat that every investor should be aware of: ‘confirmation bias’.

Human beings like to feel in control of their environment. It’s a survival mechanism. We form theories and look for patterns so that we can navigate an uncertain world with some sense of confidence that we’re making the right decisions. If we didn’t have this instinct, we’d spend most of the day sitting on the sofa, paralysed by indecision.

The trouble is, it’s very easy to get wedded to the illusion of certainty. It takes a lot of effort to build a world view that we feel comfortable with. So we hate it when our way of looking at things is challenged. Particularly if incorporating the new information would mean having to change our minds about a view that has proved useful in the past.

The discomfort we feel when we can’t incorporate a piece of information into our existing world view is called ‘cognitive dissonance’. It’s an unpleasant sensation — like an itch you can’t scratch. So it’s something that we all try to avoid.

We stock up on arguments to defend our views, and attack the opposing view. And sometimes, if we can’t give a well-argued answer to a point, we’ll resort to distraction tactics or personal attacks.

You only have to look at how defensive people get when discussing politics or religion to see this in action. Ever wanted to chuck a brick through the telly when you’re watching Question Time? (Who hasn’t?). That’s cognitive dissonance for you.

In short, we’d rather be proved right than proved wrong. So we seek out information and views that confirm our own take on things, and ignore information that contradicts it. This is ‘confirmation bias’ in action. And the higher the stakes, the more prone we become to it.

This is a big problem for investors. Because when we invest, we are backing our opinions with money. So the stakes are high.

Two Ways to Deal with Confirmation Bias

What can you do about this? The first solution is to seek out views that oppose your own before you invest. A key part of disciplined investing is to write down your reason for investing in a stock or any other asset before you do so. That way, you have a record of your thought process, which can help a lot when it comes to deciding whether to sell, or add more to a position.

But another good exercise is to try to make the case for doing the opposite of what you’re doing. So if you plan to buy a stock, try to make the case for shorting it. Write down all the reasons why this stock is going to tank, and why anyone who shorts it will make a fortune.

If you end up being more convinced by the ‘short’ story than the ‘long’ case — then maybe you shouldn’t be investing in that particular stock.

That might sound like a lot of work. But really, thinking about it, it’s not a lot more effort than you’d put into buying a new car or even a new TV. Given the amount of money that you’re probably putting at stake, you should be thinking these decisions through before you make them.

But there’s a second part to this, which is to build a portfolio that doesn’t depend on any given world view being ‘correct’. This is the secret behind diversification: making sure you don’t have all your eggs in one basket.

In effect, you want to ‘future proof’ your portfolio so that regardless of what happens in the future, you have a better chance of riding disasters out with minimal losses.

John Stepek
Contributing Writer, Money Morning

Join Money Morning on Google+

Publisher’s Note: This article originally appeared in MoneyWeek

From the Archives…

Why Waste Your Time on Gold When You Can Invest in Dividend Stocks?
19-04-2013 – Kris Sayce

A Trader’s Eye View of Gold’s Frightening Collapse
18-04-2013 – Murray Dawes

Why You Should Buy ‘Dirty, Grimy’ Gold Stocks
17-04-2013 – Dr. Alex Cowie

Why this Historic Fall in the Gold Price Equates to a Historic Opportunity
16-04-2013 – Dr. Alex Cowie

Beware the ‘Safety Bubble’, But Don’t Sell Dividend Stocks Yet
15-04-2013 – Kris Sayce



Already a subscriber to Money Morning... or simply, just like what you're reading? Then show your support and spread the word...
Share this post on...
Share

Leave a Comment

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.

If you would prefer to email the editor, you can do so by sending an email to moneymorning@moneymorning.com.au




TESTIMONIALS

"I think you're fantastic! I love to read what you write...you're so interesting and amusing and I've learned so much" -
Money Morning reader, Chris Gadd

"You guys are brilliant. I feel more relaxed about the future than ever simply because I know what is going on rather than floundering around with smoke screens and mirrors from the government and mainstream" -
Money Morning reader, Helen Carter

"Wow what can I say? I was an economically confused moron until I read your newsletter and even though I've been a subscriber for a short period I can now see how easy it is to understand, if you use common sense and can have the spin translated into everyday language. Thanks for an entertaining read." -
Money Morning reader, John

"Keep up the good independent and well thought out articles offering a view that often debunks mainstream myths." -
Money Morning reader, Craig

"I do admire your straight talking and simple analysis of the situation, I think of you as the Jeremy Clarkson of finance." -
Money Morning reader, Jeffery

FREE INVESTMENT REPORT: Why Dividend Stocks Are The Key To Retirement Wealth


In this report discover how dividend stocks can give you income long into retirement — even if stock prices don’t rise.

PLUS you'll get Money Morning every weekday...absolutely free.

Enter your email address below and hit the 'Claim My Free Report' button now.

Privacy Statement
We will collect and handle your personal information in accordance with our Privacy Policy.
You can cancel your subscription at any time

Openx pos2

  • ^NDX4103.083-2.99 - -0.07%
  • ^FTSE6837.92+18.63 - +0.27%
  • ^AORD5437.300+18.300 - +0.34%
  • ^AXJO5433.100+17.300 - +0.32%
  • AUDUSD=X0.8927
  • USDJPY=X109.02

Openx pos3

Diggers and Drillers

After three years in the doldrums…

Aussie resource stocks
are now a raging BUY
 
The last time resource stocks traded this low we saw a two and a half year rally that saw them gain 124%...
 
Now they’re getting ready to do it again. Read on to discover why…and three tiny Aussie miners that could explode up many times higher than that in 2014…click here.

Openx pos4

Openx pos5

Openx pos6

Openx pos7

Openx pos8

More Recommended Reading Below...

The Pursuit of Happiness & The Daily Reckoning

  • The Pursuit of Happiness
  • The Daily Reckoning Australia

The NSA has set up a facility in Auckland to use the XKeyscore program to harvest all kinds of mass [Read More...]

The Aussie dollar has refused to bend to the government's will. While this week it fell a few c [Read More...]

The biggest fallout — from the industry’s point of view — is the instant depreciation to your car. A [Read More...]

By demanding bonds of long duration at such low rates, smart investors are signalling that they can [Read More...]

We currently live in a time in which technology creates huge opportunity for smart investors. More s [Read More...]

Chinese money is making its way into Australian Housing, regardless of the rules. All it takes is an [Read More...]

No time or place to catch up on the financial markets today. So we will tell you a bit of what went [Read More...]

Yes folks, the China property boom is well and truly over. It’s not a bust yet, but it’s fast shapin [Read More...]

All of a sudden - we had to think about investing! Then we found ourselves coming dangerously close [Read More...]

The RBA made special mention of the risks to the Australian economy of continued house price specula [Read More...]