Why Investors Do The Crazy Things They Do – Concept 3 Confirmation and Hindsight Biases

imagesThis is the third article in this series where I discussed a concept called behavioral finance. It’s a relatively new field that tries to combine behavioral psychology theory and economics and finance to explain why people make irrational financial decisions.

We’ve already discussed Anchoring, and last time was a concept called Mental Accounting.

Mental accounting is the tendency for you to separate your money into different accounts based on subjective criteria, such as the source of the money or the goal for the money.

The third concept is Confirmation and Hindsight Biases. With these two perception and reality are definitely two different things. As an advisor, I see investors using these two concepts constantly. Including me. Let’s get into, shall we?

Concept 3. Confirmation and Hindsight Biases

Confirmation Bias
We approach life with our own opinions about people and things around us. As investors we approach money with preconceived ideas and tend to pay more attention to info that supports our opinions and ignore everything that contradicts.

In my previous article about Anchoring, I gave an example of an investor that saw a stock decline. Looking at it as a buying opportunity. That same investor would read or watch material that would support that idea. The same investor would ignore information that said the fundamentals have declined and the stock is not a good buy. This bias results in very poor investment decision making. Investors do it all the time, rationalizing good supporting info, while ignoring red flag info.

Hindsight Bias
Unfortunately, this is the one I hear from investors quite often. The hindsight bias is where investors believe that the beginning of an event (such as a market correction) was obvious and predictable. The signs were there, you should have known! If I had a nickel for every time I heard this one…

Lots of these events such as the tech bubble and the 2008 Credit Crisis seem obvious in hindsight. As investors it’s natural to try to explain away or predict unpredictable events. For investors this is a very dangerous thought process allowing them to think they have super prediction powers.

How to Avoid Confirmation and Hindsight Bias
Confirmation bias is a problem that confirms our pre-existing opinion or thought. You must have a checks and balances system to avoid it. You might want to consider a contrary opinion from someone else. Sort of a devils advocate. That way you’ll actually weigh the real pros and cons. Hindsight Bias, remember no one, and I mean no one, not even me, can predict or foresee what’s going to happen in the stock market.

Next week’s concept is Gambler’s Fallacy. You won’t to miss this one! If you want this series of articles delivered to you automatically, click here for a free subscription and have them in your email inbox every Friday morning!