Confirmation Bias, Your Investments, And The Seeking Alpha Counterpunch

by: Ray Merola

Let's start with a basic premise: recognizing and countering confirmation bias can result in actionable, investment decision-making improvements that have the ability to positively influence results.

I submit that confirmation bias is one of the more insidious pitfalls we face. I will define the term as follows:

Confirmation bias is a tendency to search for or interpret information in a way that confirms one's preconceptions, leading to statistical errors.

This psychological behavior is not limited to investors. Indeed, it prevails within nearly all human decision-making processes. However, for the investor, the tendency has point-specific consequences: you will lose money. The loss may be direct portfolio performance sub-optimization, or wasting energy battling oneself as to why investments go bad when you know "you're right" versus moving on to the next analysis / decision.

Not only will confirmation bias interfere with interpreting investment information, it will has the propensity to cause investors to ignore factual information that runs counter to their initial mindset.

It's pretty easy to see how confirmation bias can silently, yet treacherously damage our portfolios. There is no surprise in the fact that even the best investors make a lot of mistakes. Peter Lynch, the renowned master of the Fidelity Magellan Fund, noted in his book Beating the Street, that "...investors only need to be right about 60 percent of the time to make money." Most investors will agree that a big part of successful investing is not only picking winners, but dumping losers before they chew up and ruin an entire portfolio return.

Investors tend to focus upon their successes and completely ignore their failures. This has the double-duty negative effect of not only losing money / sub-optimizing gains, but we learn nothing from it.

So why do we do it?

Well, for one thing, we are human. Few of us like to hear opinions that run counter to our pre-conceived notions, let alone facts that shout out we were wrong about something. People in general, and perhaps Americans in particular, like to believe we can "control" our world. Confirmation bias is our attempt to understand the world in terms that are consistent with what we have come to believe as truths.

In addition, it takes a lot of effort to fight confirmation bias. It's tiring. Few seek sources that tell them they are wrong, then try to defend a position. Compounding matters, who wants to admit defeat when the "game isn't over." As a past athlete, I can tell you that most athletes know that once time has expired, the game is over, and score is settled, it's time to move on. However, as an investor, when has time expired? What is the "game over?" I suppose it's ultimately when our investment goes to zero. Not a particularly helpful timetable, huh? That's why we tend to hold onto sour investments much too long. One of the most damaging investment mindsets is, "I'll sell when I break even again." This statement is a close cousin of confirmation bias.

Confirmation bias is not only problematic when we process data, it even disrupts the way we accumulate data.

Who is more likely to watch Fox News or MSNBC? Read the Los Angeles Times or the Wall Street Journal? In each case, I submit it's a person whereas such information uptake tends to confirm their initial beliefs before they turned a page or hit the remote.

Fundamental investors are likewise more inclined to read about fundamental analysis than embrace the technical charts. Chartists dive into technical studies and explain why fundamental analysis is unimportant. However, there is indisputable evidence that, at times, both fundamental and technical analysis is invaluable to an investor.

So what can we do about it?

There are three things we can do to fight confirmation bias and its effect upon our investment portfolios:

Acknowledge confirmation bias and the fact that we all have a tendency to fall for it. Without a recognition of the phenomenon and its effect, the remaining two items below are worthless.

Actively seek information sources that challenge our thinking. This is much easier said than done. A simple way to begin the process is keep a record of all investment transactions, forward expectations and results. This means the winners and the losers. Then ask, "Why did this investment go south?"

Ever analyze your portfolio and come away feeling ok about it even though you had one stinking loser in it that actually caused subpar return performance? That's confirmation bias.

In addition, we must seek data sources that are not aligned with our way of thinking, nor our processes for entering or exiting a portfolio position. Given the plethora of information found on the web, this should not be too hard. Nevertheless, in practice, my friend: it is. I will not get into a discussion about true information versus internet investment "noise," but I encourage readers beware this adjunct to the premise. Indeed, if one finds data contrary to their views, but can designate it "noise," then they can find solace in having gone through the exercise of fighting confirmation bias, but have accomplished very little. Opposing views were dismissed as "noise."

Which brings me to the Seeking counterpunch

Perhaps the surest way to test our ideas is to put them before the public. In the case of SA, it contains a wide-ranging audience including many investor sets, subsets, and outliers. Readers can comment upon any publication; and they do. Commentators can offer viewpoints while safely behind their monitors or laptops; never having to physically confront another reader or contributor. This can prompt otherwise less aggressive types to jump in with both feet. I view that as generally positive stuff.

As iron sharpens iron, one person sharpens another's arguments.

Having to actively defend positions makes us better advocates. Inquiring about another position makes us think about our own viewpoints.

Best of all, the more feedback is exchanged about our investment decisions, the greater the likelihood our personal confirmation bias will be smoothed out via subsequent dialogue with others having differing points of view, and facing their own internal bias.

Seeking Alpha provides an outstanding platform to enlist opposing views on various investments and topics. The platform can help fight confirmation bias. Fighting confirmation bias helps improve investment performance. And improving investment performance is a positive bias.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.