We’re all susceptible to confirmation bias – paying more attention to our own preferred data and largely ignoring contradictory evidence. For investors, this psychological blind-spot can be very costly.
In every-day life we like to think that our decisions are logical, rational and objective but often they are anything but.
Balanced analysis frequently goes AWOL as our pre-conceived beliefs take over. Let’s take a General Election as an illustration of this point.
Voters often seek positive news that shows their favoured candidates in a glowing light while paying scant attention to information that casts the opposing candidate in a good light.
If their existing belief is that their party is always strongest on say, maintaining law and order, they may place greater emphasis on campaign speeches reinforcing this claim than independent figures showing cuts in police or army numbers.
By failing to take on board objective facts, the voter will interpret information in a manner that supports their existing beliefs.
A voter’s psychology can clearly affect where they make their cross on the ballot paper. A similar psychology can affect how traders invest.
Investors have a well-performing stock that has increased in value. They know it has made them a healthily profit but convince themselves that a good run must come to an end – and soon.
They read the message boards and broker reports and take more note of those advocating disposal rather than those suggesting a ‘buy’ or ‘hold’. They therefore decide to sell, despite abundant evidence that the rise will continue.
Finding the evidence
Confirmation bias can also occur when a share portfolio is too concentrated in the stock of a company where the investor is employed.
Given the investor’s ‘insider track’ on the company, it is easy for them to identify evidence of success at the company to justify their decision.
Being part of the operation, they will read internal news bulletins and take note of pay rises, expansion plans and earnings forecasts. They may not necessarily take an objective view of the company. How do earnings projections compare with rival firms? How is the sector itself positioned?