Investor Psychology

How to Cope with Your Confirmation Bias

We naturally tend to seek out others with similar opinions, but this phenomenon can be harmful to our portfolios.

Okay, I admit to owning a penny stock. The small company I hold a piece of has had many ups and downs in its brief history. It isn't followed by any analysts and its press releases are few and far between. Investor sentiment is key to the stock's volatile price, so I follow its message boards. But that's often an exercise in pure aggravation.

The people posting messages seem organized into two armed camps -- bulls and bears. Bulls stay bullish even in the face of big losses; bears remain bearish even when the company rings up important sales. And despite strong evidence to the contrary, bears remain paranoid about alleged secret schemes by company insiders to enrich themselves. Efforts to quell these unwarranted fears ignite immediate (and nasty) rebukes, called flames, on the boards.

Such behavior is business as usual in these forums, but it's also characteristic of a larger problem for investors, according to a group of professors who have studied message boards. That is: the human tendency not only to hear what we want to hear but also to seek out those with similar opinions. This confirmation bias is a key component of investor overconfidence, which leads us into all kinds of bad behavior, including trading too often and buying risky investments.

In search of certainty

The confirmation-bias phenomenon has been observed for eons. In ancient Greece, the historian Thucydides wrote, "It is a habit of mankind ... to use sovereign reason to thrust aside what they do not fancy."

Nowadays, confirmation bias plays out neatly on message boards. For example, the professors who followed the boards concluded in two studies that when faced with higher stock volatility, investors are more likely to show confirmation bias. That explains why the postings about my volatile penny stock are so polarized. In times of uncertainty, investors want to huddle with like-minded investors because "it makes them feel better," says Bin Gu, a professor of information management at the University of Texas at Austin and a coauthor of the studies. "The degree to which people succumb to confirmation bias could be a measure of how irrational the market is," says Gu.Further, "people become more overconfident when uncertainty is high, says Alok Kumar, a finance professor at the University of Miami and coauthor of one of the papers.

Confirmation bias is a stubborn malady, the authors admit, but the message boards give a clue to a cure. One of the studies showed that investors sought confirmation of their preexisting opinions more often when boards had "fewer objective measures" upon which to base their opinions. In fact, the more access investors have to facts and information, the less likely they are to flock to birds of a feather.

Other studies have shown that participants sometimes twist facts to support pre-existing positions. But in my chat-room experiences, I've seen that facts dropped into a sea of turbulent opinions often calm the waters -- after some knee-jerk flaming. Michael J. Mauboussin, the chief investment strategist at Legg Mason Capital Management, addresses confirmation bias in his 2009 book, Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, $30). Instead of being lured into the kind of tunnel vision that confirmation bias brings, he recommends that people "explicitly consider alternatives," "seek dissent" and "avoid making decisions while at emotional extremes."

This fits with the message-board research, from which we draw these prescriptions: Base your analysis and opinions on the facts, and ignore others' opinions that are clearly not fact-based. Test your assumptions with those who hold opposite opinions, especially in times of uncertainty. And stay the heck off message boards and out of chat rooms.

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