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Most of us like to believe that we make informed investment decisions. We may research a fund before we buy it. We evaluate how it has performed in both up and down markets. We consider its fees and look into the fund’s manager. We try to understand its strategy. This makes us feel like we’re making objective, informed decisions based on facts, but that may not be the case. We may be more biased than we realize.
One of the most common and persistent biases is called confirmation bias, a tendency to seek out information that supports what we already believe. If we think that the market will continue to rally, for example, we’re likely to give more credit to those who say the bull market still has room to run. We may end up taking on more risk than is appropriate because we think we’ll be rewarded for it. After all, there are so many smart people who point to very solid reasons why the good times are here to stay.
If we think the market is set to decline, on the other hand, we’re apt to focus on those who say stocks are overvalued or that the bull market has gone on too long. This can cause us to stay out of the market for years. After all, there are so many smart people who have very good reasons why a bear market is imminent.
We may believe that numbers can prevent us from confirmation bias, but “the tricky thing about confirmation bias is that it can look very scientific,” as Dan and Chip Heath wrote in their book, Decisive: How to Make Better Choices in Life and Work. Collecting data and running numbers makes us feel like we’re focused on facts, but we don’t necessarily see numbers objectively. When the NASDAQ Composite index crossed 5000 in March 2015, some investors saw it as a sign of a strong bull market. But others saw it as a sobering reminder of the NASDAQ’s sell-off. They focused on the fact that the NASDAQ continued to trade below its March 2000 peak. As Motley Fool’s Morgan Housel explained, “we see data without any real context of what’s good or bad, and have no idea how to interpret it. So we fit the data around our preconceived views about investing.”
Confirmation bias makes us feel like we’re making sense of the world. It taps into our need to believe that there’s some person or some data point that can help us know what the future will bring. But it can distort our view of the world and cause us to make costly mistakes.
We naturally pursue information that supports what we already believe, so we have to make a conscious effort to be aware of confirmation bias. Here are three ways you can help avoid, or at least counteract, the effects of confirmation bias:
If you think growth funds will do well, you might not spend much time considering the performance of value funds. And if you think U.S. funds will do well, you’re apt to ignore foreign funds – even if these funds start to do well. So you may want to make sure your investment process includes many different kinds of funds.
We group funds into broad categories that include domestic funds and foreign funds; funds that invest in large, established companies and funds that invest in smaller companies; and funds that focus on growth stocks and funds that seek out value stocks.
People may be susceptible to common biases, but a good investment strategy should help you avoid making biased decisions. Even if you think that technology will be the best place to invest going forward, your strategy should help to determine if now is a good time to hold tech, and if exposure to a single sector like tech is consistent with your risk tolerance and investment goals. Our Upgrading strategy prompts us to take action based on how a fund is performing compared to other funds with similar risk, not our opinions or forecasts.
If you acknowledge that you can’t always make objective investment decisions then you’ll want to have a plan that helps you determine if a fund needs to be replaced. This is built into our Upgrading strategy: we reevaluate our positions regularly, and if a fund we own falls out of favor, we sell it and move on. This process helps us identify and embrace new leaders.
The NASDAQ Composite index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. You cannot invest directly in an index.