The Confirmation Bias in Investing
Confirmation bias, in layman’s terms, is the tendency to search for and accept the information that supports their beliefs. In confirmation bias, people are more inclined toward the information supporting their previous decisions and this in return affects how they comprehend a situation, where more often or not they continue to believe what they used to believe, even if it is completely wrong.
This phenomenon is seen very frequently among investors, along with some other well documented mistakes such as excessive trading and disposition effect. This happens when investors make a thesis while making trades and are unwilling to accept information that can make their thesis wrong. Even if they see a downtrend in their investment, they continue to search for information that will support their investment rather than understanding that the decisions made by them were wrong.
One of the important paradoxes which are seen in the financial market is why trades happen in the real world when all the information is available to the public. According to the No Trade theorem, because the information is shared with common knowledge, speculations should not occur. It is so because if the investor is willing to sell his stocks in the market, this willingness will show that the stock is going to fall, as everyone in the market should do the same, and in the opposite case if an investor is willing to purchase a stock, why would someone be interested in selling that, as the signal from the investor is showing that the stock should continue to rise. But trades are happening daily in the real world. Terrence Odean examined the situation of high trading value and he concluded that overconfidence among investors may lead to high trade volumes. (Cheng, 2018)
It is seen in an earlier thesis in 1998 by Odean, that investors tend to hold stock with a downward trend and losses for a longer period hoping for future gains, and tend to sell the profitable stocks quite early. This is known as the disposition effect. After all this, there arises one question: what is the reason for the speculation? Overconfidence among investors, or the Disposition effect? The major reason which can be analysed is the confirmation bias among investors. Confirmation bias is the reluctance seen among individuals to accept information that opposes their initial beliefs which might force them to think differently. Some common real-life examples of confirmation bias seen among individuals are if we find some information that is against a candidate whom we strongly believe, we are more likely to discard that information with something that supports and promotes our belief, even in reality the first one might be true.
In the coming times, investors are moving towards virtual communities or message boards to clarify information. The increasing number of users who are using messaging boards raises the question of how investors use the information on the messaging board for their investment. It is trivial to know if the information so produced is beneficial or detrimental to an investor’s financial health.
Prior studies in accounting and finance suggest that virtual communities often provide more accurate information than analyst forecasts. (Bagnoli, 1999). These findings indicate that message boards attract insiders and informed investors and information in virtual communities can have an impact on investor investment decisions. However, research explicating how this information influences their investment performance is still evolving.
Using data from a new field experiment in South Korea, studies show how information from virtual communities such as stock message boards influences investors’ trading decisions and investment performance. Motivated by recent studies in psychology, we conjecture that investors would use message boards to seek information that confirms their prior beliefs. This confirmation bias would make them more overconfident and adversely affect their investment performance. (Park et al., 2010)
Author : Ayush Kataruka
References :
Cheng, C. X. (2018). Confirmation Bias in Investments. International Journal of Economics and Finance, 11(2), 50.
Park, J., Konana, P., Gu, B., Kumar, A., & Raghunathan, R. (2010). Confirmation Bias, Overconfidence, and Investment Performance: Evidence from Stock Message Boards.