Confirmation Bias – Understanding Behavioral Biases in Finance

Confirmation bias is the inclination to seek or make sense of news or facts in a way that validates one’s preconceptions. So, during the decision making process for psychologist they will refer to information that supports their decision more favorably. They will rarely give the obvious negative much consideration and since our beliefs and postulations are definitely prejudiced so the tendency to give more attention and weight to data that support our beliefs than we do to contrary data will subtly but gradually have a harmful effect.

An illustration of Confirmation Bias

A very real manifestation of this tendency can be observed in the virtual world. For instance, investors are increasingly turning to message boards or virtual communities to search, clarify, and exchange information before making investment decisions. The volume of discussion on such portals is so intense that it has become possible to sense stock sentiments from here. These message boards have been shown to provide more accurate and timely information than forecasts by analysts.

The reason so many investors even turn to these online communities is to gain an unbiased evaluation of the market conditions, a third-party opinion on something they might not have comprehensive information about, and the 360 degree view of the situation that can help in formulating a successful investment strategy. What in turn happens is that psychological biases, especially in such uncertain and noisy environments, affect the processing of information through these portals leading to short-sighted or impaired decision making.

It can be debated that investment-related message boards and communities do not necessarily benefit potential investors by helping them make unbiased and informed decisions, primarily because investors search for specific information on these portals that align with what they already believe. Thus, the investor interprets the information as a confirmation of his earlier beliefs, leading to overconfidence and undue optimism in said strategy and may lead to the investor making rash and irrational decisions. This may ultimately result in lower returns on investment.

Group Behavior encouraging Confirmation Biases

A theory suggested by Barber and Odean says that the illusion of control over the outcome of a chance event, the illusion of greater knowledge- assumed to be intuitive or insightful, and self-attribution biases are what cause investors to be exceedingly overconfident against better judgment. In the online world, there is more than enough information to go around. Individuals exhibit very strong opinions about the stocks they are rooting for and backed with substantial data, their opinions create the illusion of all-encompassing knowledge. Excess information is known to cloud judgment and cause investors to give greater weightage to subjective opinions as compared to objective evaluations by a disinterested entity.

Specific to online communities, the reason investors consider their peers’ opinions important is because these communities are formed when like-minded people with similar interests come together for social interactions. Hence investors are inclined to feel a bond towards the rest of the contributors on the forum.

Another explanation for this behavior can be based on cognitive dissonance theory, due to which investors try to reduce dissonances between their prior beliefs and the beliefs of the ‘group’ as they are perceived.

As per the cognitive dissonance theory, if any investor observes that the opinion he held before referring to the group, is different from a lot of the ideas shared on the group, he will try to minimize dissonance by deliberately giving greater importance to those opinions that match his beliefs and by over-scrutinizing and eventually discarding any theories otherwise. Overall, it will seem like all the opinions that matter in the group, are exactly in line with what the investor had believed in the first place. This defeats the entire purpose of seeking an objective overview of the situation.

Characteristics of Confirmation Bias 

Confirmation bias is shown to be proportional to the strength of the investors’ belief in their chosen stock position. More the investor’s conviction about his stock position, the greater is the motivation to selectively process widespread information to suit their requirements.

These investors eventually get overconfident of their own competence while trading. This has been observed in such instances whereby investors trade frequently and in turn make mistakes often. Overall, they tend to have lower returns on their investments.

Investors who are prone to confirmation biases are overly optimistic about their planned future and consequently have higher expectations from their investment performance. This optimism allows them to ignore red herrings and make obvious mistakes in spite of having prior experience.

Factors affecting Decision-making

  1. Perceived Knowledge – The investor may perceive certain information as sufficient knowledge to aid decision-making. This perceived knowledge may be a lot more than what the investor actually knows. For example the investor may feel like he has insights and data points, which are not too apparent to everyone else, which support his decision to invest in a stock. Hence every nay-sayer who theorizes otherwise can be safely ignored, since the investor believes that he has more information than they do. Someone with low perceived knowledge would never have to confidence to discard another alternate opinion so easily.
  2. Trading Experience – It can be safely assumed that inexperience contributes greatly to overconfidence. Someone with years of investment experience will have learnt the hard way about misreading market signals and will have a more realistic view of their own competence in trading. Someone with relatively less experience to go by will tend to get swayed easily by popular opinion and will be more likely to make rash decisions based on perceived knowledge. Thus overconfidence will tend to reduce with age and experience.
  3. Investment Amount – According to the theory of cognitive dissonance, the magnitude of dissonance increases when the stakes are high i.e. there are personal consequences to the decision being made. If an individual truly believes in a stock’s position and invests a huge amount of money in it, then he stands to lose a lot if the decision proves to be a mistake. Knowing this, he will subconsciously ignore any opinions which deride his decision, thus encouraging a strong confirmation bias. Any opinion that supports his decision automatically justifies the extent of his investment.

Inference

Investment performance is influenced by the frequency of trading, trading frequency and investment expectations are affected by the individual’s confirmation bias, and the extent of confirmation bias is motivated by the strength of the individual’s beliefs about a stock.

When decision-makers process information, they tend to discount evidences that misalign with their original thought process, while emphasizing the ones that confirm it. The individuals attempt to reduce cognitive dissonance by distorting available information in favor of the alternative they previously chose to contend with. The need for investors to reduce cognitive dissonance between perceived opinions causes confirmation bias among investors while seeking information in discussion groups. They would overestimate their precision with respect to decision making and underestimate any gaps in information, and thus be prone to excessive trading and other investment mistakes.