Humans are basically lazy decision-makers. We like familiarity and we look for patterns in information to streamline the decision-making process. We’d rather not spend the time and mental energy required to take an objective, deep-dive into the facts and variables of our various alternatives. Instead, we utilize a variety of decision-making shortcuts.
Let’s look at Mike for an example. Mike really wants to buy a boat for fishing and water-skiing at Lake Lewisville. He currently spends several days every summer at the lake with his wife and two grade-school-aged children. Sometimes they’re guests of a boat-owning friend, other times they rent a boat for the day. The whole family loves these days at the lake and would like to go there more often.
Mike did heavy online research of his boat purchasing options and after talking to other boat owners at the lake, finally selected a five-year old Mastercraft speed boat for $75,000.
Because Mike was predisposed to buying a boat and only talked to satisfied current boat owners—rather than independently investigating the potentially significant costs of ownership such as maintenance, storage, repairs, and ongoing expenses—he relied on the ballpark estimates of his boating friends. He was caught in the cognitive decision-making trap known as confirmation bias, whereby a person puts more weight on opinions of people who agree with them. In Mike’s case, he didn’t seek opinions contrary to his own about boat ownership. Perhaps he never heard, or ignored the common adage, “The two happiest days of boat ownership are the day you buy the boat and the day you sell it.”
Confirmation Bias can also occur after making a decision…
Betty was a self-described long-term investor. Once she bought a stock, she rarely sold it. Nearly every position in her stock portfolio had accumulated long-term capital gains. Betty was very interested in cutting edge technology and did extensive research into Hypothetical AI Cloud Solutions, Inc (HAIC), a Korean company at the forefront of the two hottest trends in the technology space. Betty was slightly concerned about HAIC’s smokin’ hot stock price, but liked the company’s long-term prospects. She bought 40 shares of HAIC at $250, a $10,000 investment.
HAIC lingered for a few months around $250, amidst general stock market weakness. Betty kept up on the company’s activities and prospects by reading the overwhelmingly bullish analyst reports and participating in positively leaning stock message boards on Yahoo and Reddit.
Then, seemingly out of the blue, HAIC was sued for patent-infringement by the largest competitor in the space. The technology accounting for 80% of HAIC’s business was allegedly stolen by a former employee of the competitor. Trading in HAIC stock was halted. It re-opened later in the day down 20% at $196.
Betty thought the lawsuit was unwarranted and sought reassurance from company press releases and the HAIC chat rooms. She remained committed to the long-term prospects for the company and held on to the stock, which kept falling. HAIC found price support at $150, the worst appeared over. Betty bought another 40 shares to bring her average cost down to $200 (80 shares at $16,000).
Soon thereafter, HAIC’s descent continued. Betty was distraught, but she held on, firmly believing they would win this patent battle and the price would recover. While most of the public commentary on this situation was negative for HAIC, she continued to look hard for information supporting her belief.
In this case, the majority opinion was correct. HAIC’s customers fled, they eventually lost the patent-infringement case and filed bankruptcy.
Betty’s $16,000 investment was worthless.
People hate to be wrong. Selling a losing investment can be an investor’s most difficult decision, because it’s the admission of a mistake.
Betty was also a victim of confirmation bias. She continued to seek information supporting her decision to hang onto MAIC and ignored or rationalized away contrary facts and data.
Counteracting Confirmation Bias Requires Intentional Awareness
An excellent philosophy to counteract confirmation bias is the concept of “strong opinions, loosely held.” This involves making firm decisions, supported by objective, current knowledge, while demonstrating the humility and flexibility required to remain open-minded to changing one’s viewpoint if new information emerges.
My business, investing and behavioral finance experience allows me to recognize and help neutralize the emotions and biases that affect my clients’ decision-making. I’m very comfortable in my role as trusted advisor, and not afraid of playing the devil’s advocate or offering a third-party, outside view on situations.