Learn to be a judge, not a lawyer, when investing in shares
When investing in shares, it's pretty hard not to get your emotions involved too. And even though you might think you're doing a good job at weighing up the pros and cons of your chosen shares, chances are you're biased. Read on to find out about confirmation bias and what you can do to counter it…
‘Confirmation bias’ – a tendency only to pay attention to data and opinions that confirm our pre-existing beliefs – is just one of our many psychological handicaps as investors.
If we own a stock, we only like to hear bullish opinions explains Tim Bennett in MoneyWeek
But the less well-known flip side of confirmation bias – ‘motivated reasoning’ – is just as dangerous, says RP Seawright, chief executive of Madison Securities.
In short, we tend to “scrutinise ideas more critically when we disagree with them, than when we agree”.
A classic 1964 study on smoking and cancer makes this clear.
Smokers and non-smokers were asked to evaluate the conclusion of the then-Surgeon General, who had linked smoking to cancer.
Non-smokers tended to agree with him, whereas smokers tended not to, quoting a range of anecdotal evidence (such as “lots of things are hazardous”) in their defence.
From an investor’s point of view, this bias explains why we fail to admit mistakes and hang onto losers, despite the cost. “We like to think we’re judges… carefully weighing the alternatives… before reaching a just and true verdict.”
In fact, we are more like lawyers: “Looking for anything – true or not – that we think might help our case.”
How do you counter confirmation bias?
Always write down why you open a trade or buy a stock. Then be systematic about reviewing your portfolio every six months or year.
If the facts have changed, dump the stock. Don’t look for reasons why “it will all come right”.
Making frequent errors is part and parcel of investing – the trick is to recognise this, take a hit when needs be, and move on.