Confirmation bias in psychology and economics refers to how we tend to search for information and interpret that information. The theory is part of behavioral finance and tries to explain how investors interpret new information.
Confirmation bias definition
What is confirmation bias? The theory behind confirmation bias states that we (unconsciously) tend to disregard or ignore information that goes against their views. Instead, we look for information that confirms our beliefs. Hence, we’re biased towards finding information that will confirm our beliefs.
Rather than carefully gathering and analyzing facts, we reach conclusions first. Then, we gather facts and interpret them in such a way that it supports our conclusions.
Confirmation bias examples
There’s plenty of examples of confirmation bias in real life. Here we present a typical case in finance.
Confirmation bias can arise when people analyze or read about companies they are already invested in. Rather than scrutinizing new information, they will tend to interpret new information in ways that confirms their beliefs. This can cause investors to ignore evidence that their investments will lose money. As a consequence, investors tend to become less critical. Instead, investors become or remain overly optimistic.
Avoiding confirmation bias
A good way of avoiding or combating the bias, is to try to adopt a contrarian approach. By playing the devil’s advocate, one might also see the shortcomings of a particular strategy. One particular technique that tends to work well, is to assume that your portfolio lost 50% of its value. What could cause such a drop? This helps you to identify the risks your portfolio might be exposed to.
Confirmatory bias is a bias that is hard to fight. However, by being more skeptical about new information, that at first sight seems to confirm our beliefs, we can limit its impact on our behavior.