Behavioural finance: Confirmation bias and hindsight bias

One often hears that "seeing is believing". Although this is often the case, in some situations what you perceive isn't necessarily a true representation of reality. This doesn't necessarily mean that there's a problem with your senses, but rather that our minds tend to introduce biases into how we process certain types of information and events.

In this section, we will see how confirmation and "hindsight bias" affect our perceptions and our subsequent decisions.

 

Confirmation bias

It can be difficult to discover something or to meet someone without having some sort of preconceived opinion. This first impression can be difficult to avoid, as people also tend to selectively filter and pay more attention to information that supports their opinions, while ignoring or rationalising the rest. This type of selective thinking is often referred to as confirmation bias.

In the world of investing, confirmation bias means that investors are more likely to seek out information that supports their original idea rather than look for information that contradicts it. As a result, this bias can often lead to flawed decisions because one-way information tends to distort investors' reference points, leaving them with an incomplete picture of the situation.

For example, consider an investor who hears some information that comes from an unverified source, he is intrigued by the potential return. The investor can choose to research the investment to see if its potential is real.

What often happens is that the investor will see all sorts of green lights on this investment (such as cash flows or a low debt-to-equity ratio), while ignoring financially disastrous red flags, such as the significant loss of clients or declining markets.

 

Hindsight bias

Another perception bias is the hindsight bias that often occurs in situations where a person believes (after the fact) that the occurrence of a past event was predictable and quite obvious, when in fact the event could not have been reasonably foreseen.

Many events seem obvious with hindsight. Psychologists attribute hindsight bias to our innate need to find order in the world by creating explanations that allow us to believe that events are predictable. This sense of curiosity is useful in many cases, but finding faulty links between the cause and the effect of an event can lead to incorrect simplifications.

For example, many people claim that the signs of the technology bubble of the 1990s and early 2000s were very obvious. This is a clear example of retrospective bias: if the formation of a bubble had been obvious, it probably would not have risen to the point of bursting.

For traders and for others who are involved in finance, hindsight bias is one of the causes of a potentially dangerous mentality: overconfidence. In this case, overconfidence refers to the unfounded belief of investors or traders who think they have superior trading capabilities.

 

How to avoid confirmation bias

Confirmation bias represents a tendency to remain focused on information that confirms pre-existing thinking. The danger of confirmation bias is that being aware of a problem is not enough to prevent you from doing something wrong. One way to overcome this bias would be to find someone to act as a "devil's advocate". In this way, you will be confronted with an opposite point of view that will have to be examined and taken into account.

Contents - behavioural finance theory

-> Behavioural finance theory
-> Flaws in conventional economic theory
-> Anchoring
-> Mental accounting
-> Confirmation bias and retrospective
-> The player's error (coming soon!)
-> Traders' herd behaviour (coming soon!)
-> Investors with excessive confidence (coming soon!)
-> Overreacting and traders' availability bias (coming soon!)
-> Prospect theory (coming soon!)
-> Conclusion (coming soon!)

Previous: Trader psychology
 Next: Why don't traders follow their trading plan?