Years ago, one of the first courses I took in college was introduction to cognition, or the science of human thought. A key concept that stuck with me long after the course, was the idea of a heuristic – a mental rule of thumb – or shortcut, that we all use in certain situations to quickly come to a decision.
Within the framework of cognition, the alternative to a heuristic is a more arduous process of collecting all relevant information and systematic reasoning to reach a decision. Daniel Kahneman explains the two different approaches in Thinking, Fast and Slow, a book I would highly recommend. As you might expect, given that we often don’t have the time or inclination to take the long way to a decision, heuristics are tools we all use.
Fast forward a few decades, and I find myself thinking about heuristics again in the context of investing and financial decision-making. Understanding when you may be subject to a particular bias can help improve your financial decision-making, but it can also provide a bit of peace-of-mind amidst the onslaught of news and opinion we seem to be subject to these days. While you can’t necessarily avoid the initial impulse biases trigger, recognizing them when they appear can help you take a step back and perhaps take a more systematic approach.
The first bias I’ll examine is confirmation bias, one of the most common and in some ways pernicious. Confirmation bias helps explain why we often stick to our opinions even when the objective facts underlying our opinions change, and why we are drawn to alarmist headlines that confirm our concerns but only lead us to be more upset.
Confirmation bias has an impact in a number of different areas – politics being among the most obvious – but it comes into play in investing as well. Even among professionals, those who have a strong belief that the economy is headed in a certain direction, or a company’s stock is bound to over or under-perform often show a persistence in that belief even as evidence mounts to the contrary. We follow a number of different forecasters, and it’s always interesting to see how some interpret the latest release of economic data to support their long-standing, closely held belief.
So how can you (and we here at Minerva) recognize confirmation bias and what can you do about it? In terms of recognizing confirmation bias, bear in mind that it is more prevalent and typically stronger when the issue is more emotional or it’s a more long-standing belief. One common situation in investing where this occurs is when investing in company stock. There are tens of thousands of .com workers who remained convinced that their stock options were going to make them rich in spite of increasing indications that the value of their companies was just an illusion.
In terms of countering confirmation bias in the investing realm, there are a couple of steps we follow, which are:
- Seek out opposing points of view and analyze them versus your beliefs. Given the overwhelming number of forecasters and pundits and the vast range of opinions, this isn’t hard to do in investing.
- Where possible, quantify your arguments and try to quantify opposing arguments as well. In investing, most of the time an argument should be at least partially quantifiable.
- Use scenario analysis to estimate the outcome if you’re correct along with the possible outcomes you don’t believe are likely.
It’s impossible to totally eliminate confirmation bias, but following the steps above help minimize any negative impact on your investment approach.