How Investors Suffer From Confirmation Bias
Last month I had the pleasure of speaking at the Midwest Private Wealth Forum in Chicago on a range of equity market topics. One of my favorite questions asked was: "What is the biggest mistake you see investors making?"
My answer: the biggest mistakes investors make today are behavioral. I've written on five behavioral biases that hurt investor returns, but my response at the event focused on confirmation bias since it is equally prevalent among professionals as it is individual investors.
Confirmation bias is the tendency to seek out information that supports your beliefs and ignore information that contradicts them. To better understand how this occurs, below is a variation of a popular logic puzzle that uses four cards to test a simple rule: "If the card has a vowel on one side, then it must have an even number on the other side." Which two cards would you turn over to test this rule?
Most people choose A and 4 because these are the cards capable of confirming the statement, but confirming evidence doesn't prove anything - the 4 card has no ability to invalidate the hypothesis. Flipping the 7 card, however, could provide valuable disconfirming evidence - a vowel on the other side means not all cards with vowels have an even number on the other side.
Much like in the card example above, investors tend to gather confirming evidence when making investment decisions rather than evaluate all available information. The impact of confirmation bias is even stronger with an existing belief since you are more likely to quickly accept evidence that supports that existing belief and closely scrutinize evidence that challenges it.