- Money Morning Australia

How Confirmation Bias Could Ruin You


Written on 24 April 2013 by John Stepek

<b>Investors</b> should be picky about the information they consume. A key psychological threat every investor should be aware of is <b>confirmation bias</b>.

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?
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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


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