What is confirmation bias?
In psychology, confirmation bias is a cognitive bias that affects the way we process information.
There is a narrow definition of the confirmation bias that only applies to the collection of information. Under this definition, most people tend to search for data and collect evidence that confirms one’s pre-existing view. We actively seek out and assign a higher value to information that confirms our hypothesis, while ignoring any evidence disproving it. Simply put, once we have formed a view, consciously or not, we are unlikely to be objective when collecting information.
There is also a broader definition of the confirmation bias that applies to the way we collect, remember and interpret information. Aside from how we gather it, two individuals with the same data may still interpret it differently, based on pre-existing beliefs each holds. Furthermore, confirmation bias can also affect what information we are likely to remember. People may selectively recall affirmative evidence even if they have been neutral in collecting and interpreting data.
Confirmation bias, in essence, is a heuristic. Or a shortcut for our brains to process information in a way that is efficient and practical. Using heuristics is common and they are usually sufficient for reaching short-term goals. Heuristics make perfect sense in the modern world where information is limitless and time to make decisions is scarce. According to evolutionary scientists, however, our minds are not designed for this environment. Because of that, confirmation bias is particularly dangerous. In combination with unlimited information, our deep-seated prejudices, often subconscious, are quickly reinforced.
Who was the first to describe confirmation bias?
Informally, confirmation bias was first observed by the Greek philosopher Thucydides, but English psychologist Peter Wason coined the actual term in the 1960s. Around that time, experimentation suggested that people are biased towards confirming existing beliefs. Later research re-framed this phenomenon as a tendency to test hypotheses in a one-sided way, focusing on one outcome and ignoring others.
An early logic puzzle developed by Wason is one of the best examples used to understand deductive reasoning and confirmation bias. Here is the test.
Most people choose to turn over cards A and 4, in an attempt to confirm the hypothesis. The right answer is A and 7 instead. The only way to falsify the "if vowel, then even number" hypothesis is by finding an instance disproving it, or "vowel and odd number". Q and 4 are irrelevant in this experiment because they can only provide confirmatory evidence.
An interesting historical example is Abraham Lincoln, who intentionally filled his government with rival politicians with opposite ideologies. To avoid confirmation bias, of course.
What causes confirmation bias?
Confirmation bias is caused by the existence of cognitive dissonance in human nature. It is a state we experience when two conflicting beliefs are concurrently held in the brain. People have a natural need to feel that their ideas and opinions are consistent. If they are not, we tend to find a way to manipulate or ignore information to achieve that state of inner balance.
There are two primary cognitive mechanisms we express this principle through:
- Challenge Avoidance - most people are afraid to find out that they are wrong. Challenge avoidance prompts us to ignore information that goes against our beliefs, thus minimising cognitive dissonance.
- Reinforcement Seeking - most people want to find out that they are right. We look for information that supports our views, which helps us deal with contradictory data and dissonance that might arise from it.
Another reason we suffer from confirmation bias is that biologically, our brains are better at understanding confirming data, especially when disconfirming data is negatively framed. This means that the way we test hypotheses is flawed.
Confirmation bias: behavioural finance in trading and investing
When it comes to investing, behavioural mistakes are common. Some, like confirmation bias, are equally prevalent among average and professional investors.
Warren Buffett famously said that “What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”
Because confirmation bias is a shortcut, it allows investors to make quick decisions. Investors tend to gather confirming evidence when evaluating information, ask questions in a way where only an affirmative response is possible and ignore contrary data. Research has shown that we can get a sense of confirmation, just by asking an affirmative question.
There are several common confirmation bias examples in trading and investing:
- For existing positions, investors search for confirming evidence and quickly dismiss data confronting their investment thesis.
- When researching an idea after getting a tip from a source deemed credible, investors tend to gather information in a biased way.
- Investors often sell winning stocks significantly before they reach the top and hold on to losing stocks for too long, also known as the disposition effect.
- Confirmation bias can lead to other known behavioural phenomena like overconfidence bias.
How to avoid confirmation bias?
The biggest challenge of dealing with confirmation bias is that it is impossible to address without being aware of the concept. Regardless of the evidence shown, if we are not cognizant, we are likely to interpret it in a way that supports our view.
Fortunately, once you acknowledge the concept, several strategies might help to keep the confirmation bias in check.
- Develop an alternative investment thesis.
Thinking about possible issues with the existing investment thesis makes investors more willing to internalise the information that contradicts it. Building an alternative investment case then allows them to collect and interpret data in a less biased way. It also reduces the probability an investor will reject contradictory information without consideration in the future. Understanding the critical negative, as well as positive, drivers of any investment improves the investor's awareness of the downside risk.
- Search for disconfirming evidence.
Investors should actively seek out people and news sources with alternative opinions. In 2013, for example, Warren Buffett invited hedge fund manager Doug Kass to participate in the annual Berkshire Hathaway meeting, giving voice to a view that contradicts his own. Kass was a critic of Buffett’s investment style and had a short position in the stock.
Investors can also choose to adopt a contrary viewpoint to their own, and argue the opposite side for the sake of argument. Avoiding asking questions that are likely to result in a confirmation of a pre-existing conclusion is yet another option in the search for disconfirming evidence.
- Accountability is key.
According to research by Jennifer Lerner and Philip Tetlock, people are more likely to think critically when held accountable by others. We are less likely to exhibit confirmation bias if we have to justify our decisions and actions. This is driven by our desire to avoid negative feedback or perception rather than an attempt to be more accurate.
- Technology is our friend.
Probably the best way of dealing with confirmation bias in investing is using advanced technology. Computers process information in an unbiased and unemotional way. They can help investors form an impartial view and overcome cognitive biases.
Ray Dalio, a founder of Bridgewater Associates, is probably the best-known proponent of technology and algorithmic investment decision making. His firm utilises principles of algorithmic decision making throughout the business, not just when it comes to investment decisions.
