What is confirmation bias?
In psychology, confirmation bias is a cognitive bias that affects the way we process information. It 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 information that confirms their existing beliefs. Later on, research re-framed this phenomenon as a tendency to test hypotheses in a one-sided way, focusing on one outcome and ignoring others.
Confirmation bias is a cognitive bias in which a person is more likely to seek out and/or believe information that confirms their pre-existing ideas.
In trading, confirmation bias may lead to making quick decisions and ignoring contradictory information.
Developing an alternative trading strategy or actively seeking disconfirming information are some methods that could help manage confirmation bias.
Confirmation bias in psychology
Confirmation bias is caused by cognitive dissonance that exists in human nature. It is the mental state where two conflicting beliefs are concurrently held in the brain.
Some people have a natural need for reassurance that their ideas and opinions are consistent. If they fail to get this reassurance, they tend to find a way to manipulate or ignore certain information to achieve that state of inner balance.
There are two primary cognitive mechanisms we usually 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. Many of us want to find out that we are right. Therefore, we look for information that validates our views, which helps us deal with contradictory data and dissonance that might arise from it.
Another reason we may 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 could be flawed.
An early logic puzzle developed by Peter 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.
How confirmation bias works
There is a narrow definition of 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. Actively seeing out and assigning a higher value to information that confirms their hypothesis, while ignoring any evidence disproving it.
Simply put, once we have formed a view, consciously or not, we are less likely to be objective when collecting information.
A broader definition 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 the pre-existing beliefs each person 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.
Consequences of confirmation bias
When it comes to trading, behavioural mistakes are common. Some, like confirmation bias, can be equally prevalent among retail and professional traders.
Warren Buffett famously said:
Because confirmation bias is a shortcut, allowing traders to make quick decisions, it could lead to them making obvious mistakes.
This is because traders often tend to gather confirming evidence when evaluating information, asking questions in a way where only an affirmative response is possible and ignore contrary data and quickly dismiss data confronting their investment thesis.
Confirmation bias could also lead to other known behavioural phenomena like overconfidence bias.
Overcoming confirmation bias
The biggest challenge of dealing with confirmation bias is acknowledging that it exists. Regardless of the evidence shown, if we are not aware, we are likely to interpret it in a way that supports our view.
Fortunately, once you acknowledge the concept, several strategies may help to keep the confirmation bias in check.
Develop an alternative trading thesis
Thinking about possible issues with your existing trading thesis and making a list with different potential outcomes could help internalise the information objectively. Building an alternative investment case then could help you to collect and interpret data in a less biased way.
You may also be less likely to reject contradictory information without consideration in the future. Understanding the critical negative, as well as positive, drivers of any trade can improve the trader’s awareness of the downside risk.
Search for disconfirming evidence
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.
It may also be useful to adopt a contrary viewpoint, and argue the opposite side for the sake of argument. While doing this, avoid asking questions that are likely to confirm a pre-existing notion.
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 could be a friend
One of the ways of dealing with confirmation bias is to use technology that can process information in an unbiased way. They could help traders form an impartial view and overcome cognitive biases.
Ray Dalio, a founder and former chief of Bridgewater Associates, is a known proponent of technology and algorithmic investment decision making. His firm uses algorithmic decision-making in many areas of their company, not limiting it to just investment decisions.
Confirmation bias is a type of cognitive bias that leads people to only seek out information that confirms their pre-existing beliefs, sometimes actively ignoring evidence to the contrary.
In trading this can often lead to traders searching for confirming evidence and dismissing data confronting their investment thesis. This could potentially lead to heavy losses, which is why traders should consider taking steps to avoid this bias.
Methods for avoiding confirmation bias could include making use of existing technology, which can process information in an unbiased way. Traders could also consider actively searching for information that could disprove their existing thoughts and ideas.
As always, traders should make sure to do thorough research before making any trading decision, taking into account their attitude towards, knowledge of markets and existing portfolio, among other factors. They should also never trade with more money than they can afford to lose.
What does confirmation bias mean?
Confirmation bias is a tendency to test hypotheses in a one-sided way, focusing on one outcome and ignoring others.
What is an example of confirmation bias?
In an example of confirmation bias, when researching an idea after getting an insight from a source deemed credible, traders tend to gather information in a biased way.
How does confirmation bias affect decision making?
Confirmation bias can lead people to gather confirming evidence when evaluating information, asking questions in a way where only an affirmative response is possible and ignoring contrary data.