Recently, we discussed hindsight bias and its impact on our investment decisions. This isn’t the only behavioral pitfall that we face as investors. Irrational thought patterns including confirmation bias, cognitive dissonance, and recency bias are often relied upon to reduce discomfort, affirm beliefs, and access information when making investment decisions.
Unfortunately, none of these generally produce the results we want in our portfolios. The good news is that there are several ways to fight these patterns.
Confirmation bias can be called “seeing what you want to see.”
This bias occurs subconsciously when we selectively gather the information that supports our claims or beliefs while at the same time minimizing (or outright ignoring) any contradictory evidence.
A good example of confirmation bias is the tendency of voters to seek out only positive information about the political candidate they support and negative stories about their favored candidate’s opponent. By not looking at the two candidates objectively, voters may miss out on important information that could change their minds.
In our post about hindsight bias, I mentioned Daniel Kahneman, author of “Thinking, Fast and Slow” and one of the founders of the field of behavioral finance. Kahneman says that it’s our attempts to believe in something that leads to confirmation bias. In his book, he says “you must first know what the idea would mean if it were true; only then can you decide whether or not to unbelieve it.”
Kahneman also says that our initial attempt to believe starts with adopting an automatic, effortless thought process. But when we decide to unbelieve, we must put more effort into thinking about how to do so.
Cognitive dissonance is defined as “anxiety that results from simultaneously holding contradictory or otherwise incompatible attitudes, beliefs, or the like, as when one likes a person but disapproves strongly of one of his or her habits.”
Author Michael Pompian, another behavioral finance expert, says that investors often suffer from mental discomfort when they discover new information that conflicts with their pre-existing ideas and beliefs. This creates cognitive dissonance. And it partially explains why investors often suffer from confirmation bias: because we don’t like the threat of alternative information — it makes us uncomfortable!
An example of cognitive dissonance is when we make losing investment decisions and rationalize them (such as blaming our financial advisor for our poor decision). However, rationalizing never helps. Instead, it keeps us from learning how to prevent similar misjudgments in the future.
Recency bias relates to investors’ ability to recall recent information more easily than information they’ve received or been exposed to further in the past. For example, data about financial markets may include long lists of complex material; many investors lack the ability to automatically capture important data points that date back several years. Not only that, but most investors may also not put sufficient emphasis on older data points, even if they do manage to capture them.
We can use the Tech Bubble as an example of recency bias. In early 2000, after four years of soaring technology stocks lifting the entire U.S. stock market to record-breaking heights, many investors—both professional and amateur—were convinced that, despite the experiences of past boom/bust cycles, things would be different this time and that tech stocks would continue to rise. We all remember how that turned out.
How to Avoid These Biases
To combat confirmation bias, we must remain mindful of the moment we begin to engage in that automatic and effortless thought pattern that Kahneman refers to that reinforces our beliefs. Only when we are aware of this can we shift our thinking by actively searching for information that presents a counterpoint to our beliefs. After we accept that there’s no such thing as a perfect investment idea, we can hold off on making a rash decision until we have assessed it with a more critical eye.
To overcome cognitive dissonance, Pompian suggests that we address our feelings of discomfort at their source and take rational action, rather than molding our beliefs or actions to accommodate those uneasy feelings.
We can fight recency bias by asking ourselves before making an investment decision if things are truly different this time. During bull markets, many investors forget how a bear market feels—and vice versa. Understanding the cyclical nature of investing can prevent investors from incorrectly basing their decisions strictly on short-term performance.
Of course, working with a third party can also help you in making rational investment decisions. An experienced financial advisor can assist in identifying your behavioral biases and come up with a plan to move past them. If you’d like to find out where your biases lie, click here to make a no-cost, no-obligation appointment with one of our advisors.