What is confirmation bias?

What is confirmation bias?

Confirmation bias is one of the most common and costly traps investors fall into. It's our deep-seated tendency to seek out information that supports what we already believe, while dismissing anything that challenges it. Combined with overconfidence, it helps explain why so many active investors consistently underperform the market.

In this video, behavioural finance expert Tim Richards explains what confirmation bias is and how it distorts the way we choose investments. He recalls a striking pattern from the days of online bulletin boards: someone would invest in a share, and if others praised it, the poster received massive support. But the moment somebody suggested it might not be such a good idea, the response was to attack the person, not the argument. We are habitually driven to seek confirmation of our existing ideas, and we find it genuinely difficult to think of ways to disprove them. Presented with a list of possibilities, we consider only what's in front of us, rarely pausing to imagine all the other things that could happen.

You'll also learn about a closely related bias: overconfidence. Many investors believe they're far better at trading than they actually are. In a 1998 study, Terrance Odean, professor of finance at UC Berkeley, analysed 10,000 US trading accounts and found that investors habitually overestimated the profit potential of their trades. In reality, their profits often failed even to cover their transaction costs, and on average the stocks they bought went on to underperform the stocks they sold.

You'll discover, too, that there may be a neurological basis for all this. Evidence suggests we're hardwired to be overconfident: in certain circumstances the brain simply weights positive information more heavily than negative. Over-optimism is a classic behavioural bias that affects almost everyone, and it may reflect nothing more than the way our brains are built.

The takeaway: as an investor, avoid simply following your instincts, and guard against the temptation to ignore information that contradicts your opinions. Be aware of your limitations, too. The markets reflect the combined opinions of millions of people, professionals included, so it simply isn't realistic for most of us to believe we have an edge over everyone else.

Chapters / Key points

• Why active investors consistently underperform the market
• What confirmation bias is
• The bulletin board example: attacking the person, not the idea
• Why we struggle to disprove our own ideas
• How overconfidence compounds the problem
• Terrance Odean's study of 10,000 trading accounts
• Why investors' profits often fail to cover their costs
• Why the stocks we buy tend to underperform those we sell
• The neurological basis for over-optimism
• Why you shouldn't assume you have an edge over the market

Transcript

What is 'confirmation' bias?

RP: Hello there. Studies have repeatedly shown how active investors consistently underperform the market. Costs play a big part, and so does behaviour. For example, we often panic when markets start falling.

But investors are also irrational when deciding which stocks or asset classes to invest in, and that's often down to something called confirmation bias. Here's Tim Richards, an expert in behavioural finance.

TR: Back in the day when I was roaming bulletin boards, it was very, very striking, there was a pattern of behaviour. People would invest in a share, and if somebody else came along and told them how much they liked it and all the good things about it, they'd get massive support. As soon as somebody popped up and said, "Well, actually, I don't think this is such a good idea," the response was to attack the poster, it wasn't to attack the idea.

We are habitually driven to look for confirmation of our ideas. In fact, we find it very, very difficult, when we are presented with something, to think of ways of disconfirming it. The brain just doesn't work that way. We are presented with a list of things, we only look at the list, we don't try and think of all the other things that could possibly happen. There is lots and lots of assertion on confirmation bias, how people just comprehensively, consistently fail to look for the things that would disconfirm their idea.

RP: Closely related to confirmation bias is overconfidence. Many investors think they're better at trading on the stock market than they actually are.

In 1998, Terrance Odean, professor of finance at the University of California, Berkeley, published a study analysing the activity of 10,000 trading accounts in the US. Odean showed that investors habitually overestimated the profit potential of the stock trades they made. In reality, the profits they made typically didn't even cover their transaction costs, and, on average, the stocks investors bought underperformed the stocks they sold.

TR: There's some evidence that we are hardwired to be overconfident. This evidence goes into some of the neurology of the way the brain works. It appears that in some circumstances, the brain is much, much happier, will weight more heavily, information that is positive than information that is negative. So, over-optimism is a classic behavioural bias, tends to affect everybody. Perhaps what we're actually seeing is how the brain actually works.

RP: So, as an investor, you should avoid simply following your instincts. You should guard against ignoring information that contradicts your opinions. You should also be aware of your limitations. Remember, the markets reflect the opinions of millions of people, including the professionals. It simply isn't realistic for most of us to think that we have an edge over everyone else.

Thanks for watching. Goodbye.