7 Ways to Combat Confirmation Bias in Investing

Confirmation bias can destroy a portfolio.

There is a natural tendency to use new information to validate pre-existing beliefs. At the same time, there is the same tendency to dismiss that which conflicts with those held beliefs.

This can create an echo chamber, resulting in poor financial decisions. Investors may overconcentrate in assets they feel positive about, disregard warning signs of a downturn, and hold onto losing investments for far too long, hoping for a rebound that aligns with their initial optimistic outlook.

Confirmation bias isn’t just limited to individuals, but also CEO and consensus outlooks by Wall Street. Let’s take a look at some historical cases, as well as seven ways we can fight back against the perils of confirmation bias.

Historical Examples of Confirmation Bias by Wall Street

The Dot-Com Bubble

During the late 1990s, the rise of the internet fueled speculation in technology stocks. Investors caught up in the narrative of a new economy, eagerly poured money into internet-based companies, often with little to no revenue or a clear path to profitability.

The confirmation bias was rampant as investors focused solely on the potential of these "dot-com" companies and sought out information that validated their belief in a paradigm shift. Traditional valuation metrics, such as P/E ratios, were often dismissed as outdated. Negative news and skeptical analyses were largely ignored in favor of success stories and a herd mentality.

When the bubble burst in 2000, trillions of dollars in market value evaporated, and many investors lost their life savings.

The 2008 Housing Crisis

The lead up to the 2008 financial crisis was characterized by a widespread belief that housing prices would always go up. This belief was a case of collective confirmation bias.

Homebuyers, lenders, and investors in mortgage backed securities all operated under this assumption, seeking out and emphasizing information that supported this view.

Rising home values for many years served as constant confirmation. Lenders relaxed their standards, offering risky subprime mortgages, and investors eagerly bought them.

Soaring home prices confirmed the wisdom of these decisions. Warnings from a minority of analysts about an unsustainable housing bubble were largely dismissed.

When the bubble inevitably burst, it triggered the global financial crisis, leading to widespread foreclosures, the collapse of major financial institutions, and the Great Recession.

Confirmation Bias in Individual Stocks

Let’s take a look at some historical examples of individual stocks and the effects of confirmation bias.

BlackBerry (Research in Motion)

In the mid-2000s, BlackBerry was the undisputed king of the smartphone market. Its devices were addictive, and its corporate use was dominant.

When Apple's iPhone was introduced in 2007, many loyal BlackBerry investors and executives suffered from a severe case of confirmation bias. They believed BlackBerry's strengths of a physical keyboard, security features, and enterprise adoption would keep them at the top.

Many dismissed the iPhone as a "toy" for consumers that lacked the serious features business users required. Analysts often questioned the iPhone, even a year after its release.

Just read this news headline from 2008.

As the iPhone's market share grew exponentially and the Android operating system emerged, BlackBerry investors clung to their initial thesis, convinced that the company's established position would win.

This refusal to acknowledge a fundamental market shift caused them to hold the stock during its decline from which it never recovered.

Blockbuster

For decades, Blockbuster was the undisputed leader in home movie rentals. Its brand was synonymous with movie nights, and its vast network of physical stores seemed like an impenetrable moat.

As Netflix began gaining traction in the mid-2000s with its DVD by mail service (and later streaming), many Blockbuster investors fell victim to confirmation bias. They focused on Blockbuster's massive revenue and market share, confirming their belief in the company's dominance.

They dismissed Netflix as a niche service, believing customers would always prefer the "experience" of browsing in a physical store and the instant gratification of renting a movie without waiting for it to arrive in the mail.

Two years before Blockbuster declared bankruptcy, in an interview with the Motley Fool, Blockbuster’s CEO said they didn’t even perceive Netflix as a threat.

“Neither Redbox nor Netflix are even on the radar screen in terms of competition.”

No wonder Blockbuster went out of business shortly after. These investors ignored the clear trend towards convenience and the growing consumer frustration with Blockbuster's late fees.

By clinging to the belief that the old model was superior, they held on as Blockbuster's business model became obsolete, leading to its bankruptcy in 2010 and a total loss for shareholders.

7 Ways to Combat Confirmation Bias

Now that we know confirmation has wrecked many markets, and stocks, how does one combat confirmation bias? Here are seven ways that can help any investor make better informed decisions.

#1 Establish a Clear Investment Thesis

The first thing investors can do is clearly define what their investment thesis is and why. It’s best to write this down to make it clear to memory.

This thesis should state the metrics or milestones that you believe should become reality if the thesis is correct.

By referring to this original thesis overtime, one can identify if the business is performing to expectations, rather than shifting goalposts as a business could potentially deteriorate or fall short of expectations.

#2 Benchmark the Business vs Its Industry

It’s common for a business to give a plausible excuse or reason for declining sales or declining numbers. For instance, BlackBerry and Blockbuster certainly had their excuses.

This is why we must always look at performance of a business vs its competition and the industry at large. If the entire industry is in decline, it can be understandable why a business you own in that industry is in decline too.

However, if a business is in decline and competitors are gaining traction, or growing faster, that is a red flag. This could be a sign of an eroding moat or product market fit failure.

#3 Diversify Sources of Information & Seek Dissenting Opinions

If your information network is limited to those who share your beliefs, you are in an echo chamber. Doing so will only reinforce your existing views.

Follow a wide range of financial news outlets, analysts, and commentators with varying perspectives. This will ensure you will come across different viewpoints that highlight both bearish and bullish news, rather than only news that reinforces currently held beliefs.

There should also be an active attempt to seek out dissenting opinions. There will always be those that disagree in an open market. Whether the dissenting opinions are correct or not are not the point here, but rather, by seeking out dissenting opinions, one has a grasp of what the contrary opinions are.

If you're bullish on a particular stock, make a concerted effort to read bearish analyses. This forces you to consider the potential downsides and weaknesses you might have otherwise overlooked.

#4 Focus on the Data, Not Just the Narrative

Emotions can drive confirmation bias. Instead of getting caught up in the story behind a stock, focus on the objective data as it becomes available.

Are revenues and earnings growing? Is the company's debt manageable?

Let the new data, not the narrative, guide your decisions. Eventually, inputs become outputs. The outputs should eventually follow the narrative in your thesis established in #1.

#5 Create a "Pre-Mortem"

As legendary investor Charles Munger said, invert, always invert. Imagine that your investment has failed. Now, work backward to identify all the potential reasons for this failure. This exercise helps you to anticipate risks and weaknesses in your initial thesis before you've invested any capital.

#6 Keep an Investment Journal

Investing is a longterm endeavor. Over years and decades, the businesses you buy will evolve. Some will fail, some will succeed. In order to keep track of your thoughts and how you reacted, create an investment journal.

Document your reasons for buying and selling each investment. This will allow you to go back and analyze your decision making process, helping you to identify instances where confirmation bias may have led you astray.

#7 Conduct Regular Portfolio Reviews

Don't just set it and forget it. Periodically review your portfolio and re-evaluate your initial investment theses. Are the reasons you initially invested still valid? If not, it may be time to sell, even if it means admitting you were wrong.

In Summary

It's easy to look back at the Dot-Com bubble, the 2008 crash, or the demise of once popular businesses like BlackBerry and think we would have seen it coming.

The reality is, confirmation bias is a powerful and subtle force that can trap even the smartest investors in an echo chamber.

The good news is that you can build a defense against it. The seven strategies outlined here provide a framework for making decisions that force you to question assumptions and prioritize facts over emotions through disciplined investing.

If you enjoyed this article, you may also be interested in reading How Information Overload Leads Investors Astray.

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