How Confirmation Bias Affects Investment Decisions

Using personal judgment to conduct due diligence may not be the optimal way to make business decisions. Many psychological studies show how our decision-making capabilities are limited due to the biases that are inherent in human nature. While the phrase ‘“go with your gut” may have positive implications, in reality, it could be fueled by “confirmation bias” — with disastrous repercussions for investors and decision-makers.
By Peter Gorne
August 23, 2021

Confirming the Confirmation Bias Definition

We have all heard the saying, “I’ll believe it when I see it.” But we’ll soon discover that the saying should have been written in reverse. “I’ll see it when I believe it” is actually the more accurate phrase, due to what psychologists call confirmation bias.

Confirmation bias is a cognitive phenomenon that causes people to validate incoming information that supports their preexisting beliefs, and to reject or ignore any contradictory information. It is, essentially, seeing what you expect to see and hearing what you expect to hear. In the financial sector, investors rely more strongly on and spend more time focusing on information that confirms their preceding knowledge or opinion about a given investment opportunity.

Examples of Confirmation Bias

An example of the disastrous effects of confirmation bias is evident with the investors of the infamous blood-testing startup Theranos. Among the very prominent investors in the company was George Shultz, the former Secretary of State. Shultz was not only an investor — but he was also a close personal friend of the Holmes family, whose daughter founded the company at the young age of nineteen. As a result, when Shultz’s grandson, Tyler, presented him with fact-based evidence that Theranos was a complete scam, Shultz refused to believe it. Tyler presented him with information that was contradictory to his preexisting beliefs. Essentially, the do-no-harm perception he had of the startup clouded Shultz’s judgment. The result? This bias cost Shultz millions of dollars.

Another example of confirmation bias in action is the rise of “fake news.” As social media has become the primary source of news in the United States, there has been a dramatic rise in content of questionable accuracy. Here, confirmation bias works to make people more likely to believe messages they have read previously. Repeatedly seeing inaccurate information makes you more likely to believe it, despite its lack of credibility. In many cases, this could be harmless gossip or unrealistic weight-loss suggestions, but fake news is now acknowledged as impacting the political process.

Why People Experience Confirmation Bias

The simple reason is that our brains are not designed to analyze so much information. In order to survive and make life-or-death decisions, our brains have adapted to process information quickly. That speed comes from making associations that guide our instinctive reflexes.

Instead of assessing the full range of available information to reach a balanced conclusion, we are wired to formulate a hypothesis (or apply past impressions) and then search for information that supports that hypothesis. One study described this as enabling “us to find the ‘needle’ much more easily since we would not have to search the whole ‘haystack’.”

The Power of Association Heuristics

In more involved cognitive tasks, we also rely on our power of association. Psychologists talk about heuristics — shortcuts in thinking that help us reach a solution to a problem as efficiently as possible. These associations help us solve the crossword puzzle but they can cause errors in judgment. This happens because heuristics lead us to base our thought process on our memory of past events or what we think should occur, rather than assessing the presented information with an open mind.

Cognitive Dissonance Makes Holding Two Ideas Uncomfortable

Another reason for the prevalence of confirmation bias is cognitive dissonance. Cognitive dissonance is an emotional state that results from the conscious understanding that two conflicting beliefs are being held concurrently in the brain. In other words, people have an innate need to ensure that their beliefs and ideas are consistent — and when they feel those are not, they subconsciously try to manipulate or ignore facts to achieve an inner state of harmony and balance. It is uncomfortable to believe two opposing facts — and therefore, our brains are wired to remove the discomfort by dismissing one of those facts.

In the case of Shultz, accepting that the company in which he invested millions of dollars was a scam would be inconsistent with what he believed about Holmes. On one hand, Elizabeth Holmes was a dear, trusted friend. On the other hand, her company was a total fraud. These two pieces of information don’t go hand in hand — so Shultz’s mind rejected the information presented to him by his grandson, in order to return to a state of cognitive equilibrium.

Confirmation Bias and Investment Decisions

With this understanding, we can now see the great potential for confirmation bias to impact investment decisions. In his book Making Money Simple, Peter Lazaroff writes that the biggest mistakes investors make are behavioral. He outlines five major behavioral biases that hurt investors’ returns, one of them being confirmation bias. “Investors tend to gather confirming evidence when making investment decisions rather than evaluate all available information,” he says. Lazaroff further explains that investors tend to ask questions in which positive responses elicit confirmatory beliefs. This is problematic because the only way to answer these questions accurately is through supporting data. Therefore, investors tend to focus on information that confirms their preconceived ideas about an investment, thus leading to biased financial decisions.

“Investors tend to gather confirming evidence when making investment decisions rather than evaluate all available information”

In a study of online investment communities, researchers found the confirmation bias in great effect. You might think that virtual communities were a good place for investors to share information and decrease the impact of confirmation bias. However, studies have found that with the vast amount of information available online, easy access to this information has only continued the confirmation bias.

When researchers looked at the difference between “value” and “glamor” investment styles, they found that confirmation bias not only played a big role, it varied depending on which investment style was used. Value investors tended to underreact to “good information,” while they either reacted fairly or under reacted o negative information. Conversely, glamor investors were likely to underreact to negative information, while positive information was either treated fairly or overemphasized.

Confirmation Bias in Hiring

Confirmation is a serious issue in the hiring process, particularly in executive hiring or when choosing fund managers as so much is riding on selecting the best personnel. When a hiring manager interviews a candidate, they are immediately making assumptions about that candidate. Subconsciously, if they like the candidate, they are likely to ask less probing questions in the interview process. If the candidate’s background check is conducted in an equally subjective manner, then essential information can be easily overlooked.

One study examined what happened when participants were shown a candidate profile that listed both extroverted and introverted skills, and then asked to recommend her for either a librarian or salesperson position. Participants who remembered the candidate’s extrovert skills more clearly were most likely to suggest her to be a salesperson, and those who remembered her introvert traits recommended her to be a librarian.

This is related to the “halo effect,” where people use impressions of a single trait to form conclusions about unrelated attributes. It is heavily influenced by the first impression we make of someone. It is for good reason we say that first impressions matter the most; in very many settings they do, because it is hard for us to think beyond them.

This can have a particularly profound impact on companies looking to increase diversity in their hiring processes. Existing subconscious beliefs about ethnic groups or gender can hamper our ability to give candidates a fair assessment in the hiring process.

How to Avoid Confirmation Bias in Investment decisions

Thankfully, there are numerous ways to avoid the repercussions of confirmation bias, specifically regarding investment and due diligence decisions. First, awareness and acknowledgment that confirmation bias exists is necessary in order to overcome its effects.

How to avoid confirmation bias? Here are five simple steps:

  1. Treat initial data gathering as a fact-finding mission without reaching any conclusions about the findings.
  2. Identify three causes for each item of interest or fluctuation in the financial data (if looking at an investment).
  3. Present the areas of interest to a colleague to see if they come to the same conclusions as you.
  4. Look for evidence that disproves your initial hypothesis.
  5. Return to see if you can find any new information.

Thankfully, there are numerous ways to avoid the repercussions of confirmation bias, specifically regarding investment and due diligence decisions

In his book Root Out Bias from Your Decision-Making Process, Thomas C. Redman comments, “it’s a rare luxury for leaders to have all the relevant information before making a decision.” He emphasizes the importance of finding information that supports the opposite decision as well as the one you have made.

So once an investor has amassed information about an investment opportunity, he or she should seek information that may be contrary to their point of view. The investor can also use an independent third party to weigh the alternative viewpoints and assess the information objectively.

Another way to avoid the consequences of confirmation bias is to avoid asking questions that would naturally lead to conclusions that support your bias. Ted Jenkins, co-CEO and founder of oXYGen Financial, writes that one of the four ways to prevent falling victim to confirmation bias is to avoid asking leading questions. For example, a question like, “I heard the iPhone X is going to help Apple boost the price of its stock, so now is a good time to buy, right?” causes an investor to answer the question based on preconceived notions.

Removing the Risk of Confirmation Bias

At the heart of confirmation bias is the human inability to accurately assess large bodies of information. But what if you didn’t have to? New developments in risk analysis for investment due diligence bring the power of AI to company and executive background checks and remove the risk of confirmation bias.

Artificial intelligence (AI) systems have an unprecedented capacity to analyze vast quantities of data in minutes. AI is already changing the way we live our lives, from selecting our music choices to detecting potential heart attack patients before the event occurs.

In the area of executive and company risk intelligence, AI is bringing a new level of accuracy to information gathering and decision making. AI-powered systems are able to collect and assess hundreds of thousands of data points, cross-referencing items to ensure correct data matching, and providing a confidence score for each item.

Unlike a human analyst, AI-powered systems are completely free of confirmation bias.

No prior conclusions exist; raw data is simply reviewed and categorized. The Intelligo Clarity platform is one such system. The Clarity system flags relevant pieces of information with color-coded “flags” so users can quickly understand the severity of any issue. Links to original source material are provided so that users can review the data and arm themselves with a complete understanding before reaching any decision.

 

Confirmation, Contradictions, and Conclusions

Confirmation bias is a natural occurrence that once kept us safe from physical harm. However, in today’s technological age, it has itself become a force for harm, keeping us from accurately assessing information. Thankfully, our technological age has developed an answer to this challenge. The power of artificial intelligence is enabling investors to overcome confidence bias by providing accurate, timely information on companies and individuals. By removing humans from the information gathering process, we are able to overcome this very human challenge.

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