How Confirmation Bias Affects Investment Decision Making

Using personal judgement to conduct due diligence may not be the optimal way to make business decisions. There are many psychological effects that 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 lead to gut wrenching decisions that have disastrous repercussions for decision makers.
By Ariella Serman
April 14, 2021

Confirming the Confirmation Bias Definition

We have all heard the saying, “I’ll believe it when I see it” and most, if not all of us, can completely relate to its implications. But what we will soon discover is that the saying seems to 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 reject or ignore any contradictory information. It is, essentially, seeing what you want to see and hearing what you want to hear. In the financial sector, investors rely more strongly and spend more time focusing on information that confirms their preceding knowledge or opinion about a given investment opportunity.

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 Schultz, former Secretary of State. Not only was Schultz an investor, but he was also a close personal friend of the Holmes family, whose daughter founded the company as the young age of nineteen. As such, when Schultz’s grandson, Tyler, presented him with fact-based evidence that Theranos was a complete scam, Schultz 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 judgement. As a result, it cost him millions of dollars.

Confirmation Corroboration

Why do people experience confirmation bias? The main psychological principle explaining the prevalence of confirmation bias’ existence in human nature is cognitive dissonance. Cognitive dissonance is an emotional state experienced by an individual which results from the conscious understanding that two conflicting beliefs are concurrently being held in the brain. In other words, people have an innate need to ensure that their beliefs and ideas are consistent, and when they feel they are not, they subconsciously try to manipulate or ignore facts to achieve an inner state of harmony and balance.

In the case of Schultz, accepting that the company he invested millions of dollars in 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 and therefore Shultz rejected the information presented to him by his grandson to return to a cognitive equilibrium state.

Confirmation Bias and 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 the confirmation bias. “Investors tend to gather confirming evidence when making investment decisions rather than evaluate all available information.” 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 is through supporting data rather than exhaustive data. Therefore, investors tend to focus on information that confirms their preconceived ideas about an investment leading to biased financial decisions.

How to Avoid Confirmation Bias

There are numerous ways to avoid the repercussions of confirmation bias, specifically in regards to investment and due diligence decisions. Firstly, being aware of and acknowledging that confirmation bias exists is necessary in order to overcome its effects. 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.

Additionally, using technology such as artificial intelligence and machine learning helps to create an unbiased and comprehensive overview of the person or company being evaluated. This can help investors use an objective cognitive compass to overcome any biases they may be subject to. Especially useful is making use of these technologies to acquire all relevant data related to the individual or company in-question, most often completed through the background check process.

Another way to avoid the consequences of confirmation bias is to avoid asking questions that would naturally draw to conclusions that support your bias. Ted Jenkins, the 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, asking a question like, “I heard that 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 for themselves based on preconceived notions.

Confirmation, Contradictions, and Conclusions

Confirmation bias is one of the many psychological principles that affect investors’ decision making capabilities. It leads investors and due diligence decision makers to negate information that conflicts their preexisting biases, and only accept information that validates their positions. While all individuals are susceptible to its influence, it is important for investors to recognize its existence and to try to avoid the biasing effect that it can have on investment decisions.

You may also like:

Due Diligence 2021 – Join the AI Revolution

Due Diligence 2021 – Join the AI Revolution

AI and machine learning have the capability to refine business practices, enabling firms to achieve their overarching goals. Due diligence is a prime example of an industry in which the application of artificial intelligence can help firms actualize their objectives of absolute transparency. By reducing natural human errors, eliminating manual inaccuracies, and automating internal operations to increase productivity, AI is transforming industry norms.

read more