Behavioural finance is a field of behavioural economics that deals with the psychological influences and biases that affect investors. These biases exist in the decisions that investors make and can cause them to make the wrong choices. There are several types of biases that investors may face during their investing process. One of these includes confirmation bias.
What is Confirmation Bias?
Confirmation bias is a type of bias that occurs when investors prefer information that confirms a belief they have had previously. Their belief may not be correct. However, since they come across information that supports it, investors tend to favour that information. Some investors may also actively seek out information that confirms their beliefs.
Confirmation bias also represents the bias that investors may have against any information that does not support their beliefs. Usually, investors tend to put more focus on any information in support of their views. When they come across information that contradicts their belief, they ignore it. Confirmation bias can, therefore, lead to irrational investment decisions by ignoring crucial information.
How does Confirmation Bias work?
Confirmation bias starts from a preexisting belief that individuals have. These beliefs may or may not be true. When looking for investments, these individuals will look for information that supports their views about the decision. During the process, if they come across any information that disregards their beliefs, they tend to ignore it. Usually, they don’t do so deliberately. Instead, this process occurs unintentionally, and they don’t have any control over it.
When investors come across any information that confirms their beliefs, they gain confidence in it. They may look for further evidence to support their preexisting views. The more information they come across in support of it, the more reliance they develop over it. As a result, they will end up making the wrong decisions. These decisions can relate to buying or selling stocks or the type of investment they make.
Confirmation bias doesn’t only apply to finance or investing. It is prevalent in all fields of life. One of the simplest ways of protecting against confirmation bias is to realize it exists. However, that may not be possible since it is a subconscious process. Individuals can also reduce confirmation bias in their dealings by obtaining a second opinion or studying contrasting beliefs.
What is an example of Confirmation Bias?
An investor comes across an opinion that suggests that the real estate market will boom in the future. The investor believes the opinion is accurate. Based on that opinion, the investor seeks investments in the real estate market. During the analysis phase, they come across various publications that suggest the real estate market will go down.
Although the information contradicts the original opinion formed by the investor, the investor does not consider it. Instead, the investor actively searches for publications that confirm their view. Eventually, the investor comes across an unverified article that presents the same opinion as to their belief. Based on that information, the investor invests in the market.
However, the real estate market goes down, and all real estate value falls. The investor makes a significant loss for investing in the market. In this scenario, the investor developed confirmation bias when they chose to believe an unverified article instead of several publications.
Conclusion
Confirmation bias is a type of bias that occurs when investors favour information that confirms their preexisting views. They actively disregard any information that contradicts their opinion and instead seek out information that validates it. Based on this, they make decisions, which leads to losses in the future.
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