Secular vs. cyclical and the challenge of confirmation bias

To be a successful financial adviser, especially during times of volatility, it pays to understand and master the human cognitive biases that can often lead to poor decision-making. No doubt the recent share market rout has caused many investors to make poor decisions as a result of taking shortcuts or by being overconfident or oversimplifying a complex decision.

As a financial adviser, making the right decisions matters. Not just for your client’s investment returns but for your confidence as well. Knowing your cognitive biases can therefore lead to better decision making, lower risk and enhanced investment returns for your clients.

There are in total ten cognitive human biases:

1. Anchoring bias
2. Confirmation bias
3. Information bias
4. Loss aversion bias
5. Incentive-caused bias
6. Oversimplification bias
7. Harry Hindsight bias
8. Bandwagon bias
9. Restraint bias
10. Neglect of probability bias

Confirmation Bias

The term confirmation bias describes how people naturally favour information that confirms their previously existing beliefs. It’s the tendency to search for information that matches some of our preconceived notions. Consider for instance the concept that technology companies had become secular rather than cyclical growth opportunities, there was more than enough data to support this, but those able to challenge the conventional wisdom were able to avoid the worst of the current selloff.

Investors unconsciously search for information that confirms their existing beliefs and ignore facts or data that refutes them, they may skew the value of their decisions based on their own cognitive biases. This psychological phenomenon occurs when investors filter out potentially useful facts and opinions that don’t coincide with their preconceived notions.

According to Investopedia, the key characteristics of confirmation bias are:

• The tendency to actively search for, interpret or retain information that matches preconceived notions and beliefs.
• It flourishes because it’s an efficient way to process information, it promotes self-esteem, and it eases stress by eliminating conflict and contradictions.
• Investors should be aware of their own tendency towards confirmation bias so that they can overcome poor decision-making, and missing chances, and avoid falling prey to bubbles.
• Seeking out contrarian views and avoiding affirmative questions are two ways to counteract confirmation bias.

An example of confirmation bias could be when a client over-invests in a particular stock and keeps dumping more money into it, finding data and news articles to support this, but tends to ignore any unfavourable news about that company.

To reduce the risk of confirmation bias, the first step is to admit it exists.

Only once we become aware of it can we look to address it. Following this we need to look at other points of view and listen to the other side of the argument. And this must be done with an open mind. 

According to Mirae Asset Management, “Seek contrary opinions, even if those opinions may seem uncomfortable to you at first. Try to understand the rationale behind the contrarian opinions. Do not rely on just one source of information to form opinions about a product. Look at multiple sources of information. Knowledge is your biggest friend in overcoming investor biases. Increase your investment knowledge about different investment concepts, financial markets and the economy to make better investment decisions.”

Ishan Dan

Ishan is an experienced journalist covering The Inside Investor and The Insider Adviser publications.