Investor Behavior: Confirmation Bias

How dangerous is confirmation bias if left unchecked?

By Financial Advisor Peter Egolf

Behavior is one of the most overlooked parts of investing, even among financial advisors. Investors are so focused on producing outsized returns that they overlook the fact that their behavior can be the foundation for the returns they want.

As an investor, it is easy to get stuck in a loop of your own biases, even if you have a financial advisor. The critical realization is understanding your information's source(s) and whether you seek information to approve your beliefs. More importantly, investors should be seeking out information to disprove their beliefs.

Herein lies the problem. Investors receive or seek out information from the media and the financial industry. These two industries profit from destructive behavior. For media, the point is to engage consumers. There is low engagement when you explain that the market is fine (and probably will be in the long-term) and you should stay the course as an investor. Similarly, the financial industry profits substantially on transactions and products. If investors buy and hold an investment, that does not lead to profit. These industries confirm the worst fears of investors, which can lead investors to make poor behavioral decisions that hurt their returns and wealth.

"It's no wonder that, as brilliant research by the psychologist Paul Andreassen showed many years ago, people who receive frequent news updates on their investments earn lower returns than those who get no news. It's also no wonder that the media has ignored those findings."¹

As an investor, your behavior is paramount but is often ignored. We encourage our clients to seek out information that is not in everyday headlines (e.g., academic research).

How can confirmation bias affect investment behavior?

Confirmation bias is one of many behavioral biases that push investors to make decisions that are not in their best interest. It is centered on selectively choosing information that strengthens one's beliefs or values. If your advisor has conflicts of interest or you, as the investor, only look at specific pieces of information, you can hide the truth and actual results.

For example, if you invest in a taxable account and look at its one-year performance, you see that the mutual fund has had a 20% return.

You compare this to a similar investment that has a 19% return. You conclude that you picked the better investment.

Yet you ignored obvious information. Your fund had upfront sales charges, and the distributed capital gains reduced your return, making your net return worse than a similar investment.

You believe you have the better investment and selected evidence to confirm the truth, but the truth is the contrary.

As investors, it is crucial to be self-aware of your biases or have someone who can check them (while avoiding their own conflicts) to prevent behavioral mistakes.

At One Day In July, we believe that many investors can benefit from improved behavior. As fee-only fiduciaries, we put our clients’ interests first. We want to support you by helping you exhibit excellent investor behavior. If you want to learn more about being a client, please get in touch with me to schedule a conversation.

1. The Intelligent Investor: Saving Investors From Themselves – Jason Zwieg