Meaning of Confirmation Bias
Confirmation bias is a term from the cognitive psychology field, which describes how people naturally favour information that confirms their previously-existing beliefs.
Behavioural finance experts identify that this fundamental principle applies in notable ways to the investors. Since investors are looking for information that confirms their established opinions and ignores conflicting information that refutes them, they can distort the value of their investment decisions based on their own cognitive biases. This psychological phenomenon comes about when investors filter out potentially useful facts and opinions that do not match their preconceived notions.
How to Overcome Confirmation Bias?
*Get Contrary Advice: *The first step to overcoming confirmation bias is to be aware of the existence of the bias. Once an investor has obtained information that supports their views and beliefs about a particular investment, they will look for alternative proposals that contradict their perspective. Making a list of the pros and cons of the project and reassessing it with an open mind is good practice.
*By Avoiding Confirming Questions: *Investors shouldn't pose questions about an investment that validate their assumptions. For example, if they only ask their financial advisor about the valuation of the company, an investor who intends to purchase a stock since it has a low price-earnings (P / E) ratio is likely to confirm their results. A better plan would be to get more stock information from the broker to form an unbiased conclusion.
A Scenario of Confirmation Bias
Assume an investor is hearing a report that a corporation is on the brink of declaring bankruptcy. The investor is considering to sell the stock based on that information. When they go online to read the company's latest news, they read only the stories that confirm the likely scenario of bankruptcy and miss a story about a new product that the firm has just introduced that is anticipated to perform well and increase sales. The buyer, rather than keeping the stock, may go about selling it at a significant loss just before it turns around and reaches an all-time high.
