Amongst all the various cognitive biases that cause human beings to think and act irrationally, one of the more insidious ones is known as confirmation bias. Simply put, it means we tend to favor information that supports previously existing beliefs, and tend to reject anything that does not.  How much of a problem is confirmation bias when it comes to investing, and how can we recognize and avoid it?

Let’s start with an illustrative example from the world of politics, where confirmation bias is totally ubiquitous. Let’s say you have always believed that Muslims are terrorists.  (Personally I find it astounding that a U.S. presidential candidate would share such a belief in public.)  One day you watch a news report about an attack for which the terrorist group Al Qaida claims responsibility.  You will likely use that data point to strengthen your belief, consciously or subconsciously.  Suppose the next day, however, you read about a mosque in Texas that collected money to support local residents whose homes were destroyed in a flood.  You will likely consider that to be an anomaly or find a way to make up details to suit your belief (e.g. I’m sure the beneficiaries were just other Muslims).

The scary thing is that we do this in almost all aspects of our lives. And when it comes to investing, such behavior can be very self-destructive.  For example, suppose you’re holding a European stock mutual fund that has been very volatile of late, making you nervous.  You read a brokerage report downgrading the fund, which reinforces your growing belief that it’s a poor performer.  When you run across a news article a week later about an award that the fund manager is about to receive, you ignore it on the grounds that it’s must be based on something he did in the past.  You finally sell the fund, at which point you’ve not only realized a loss, but have also unbalanced your portfolio.  To add insult to injury, the fund subsequently takes off.

Confirmation bias also influences how people interpret and recall information. Bob Seawright, Chief Investment Officer for an investment advisory firm in San Diego, reports on studies that have determined that the easier it is for us to collect and validate data, the more comfortable we are accepting it.  And when it comes to predicting what particular stocks are going to do well or poorly, our decision making is significantly colored by this type of cognitive bias.  Confirmation bias leads to overconfidence, which explains in part why bulls tend to remain bullish and bears tend to remain bearish regardless of what is actually happening in the capital markets or in the economy.

So what can we do about confirmation bias?

• Recognize that we don’t know what will happen in the future but have lots of unfounded beliefs about it. Base investment decisions not on predictions but rather on a sound investment strategy (how much you actually need to grow your investments over an appropriate investment horizon).
• Follow your investment strategy no matter what is going on in the world. Warren Buffett has been extremely successful taking this approach.
• Assume you may be wrong, so always diversify as much as possible.
• Ignore the media and don’t accept statements at face value, especially those that support what you already believe. To validate data requires due diligence. Do it yourself or hire someone unbiased to do it for you.

In short, don’t believe everything you believe.