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The Dangers of Confirmation Bias

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Behavioral finance represents the marriage of traditional financial theory and psychological principles. Traditional financial theory posits that economic actors are fully rational, making unbiased, wealth-maximizing decisions after considering all available information. Of course, we all know that the economic world does not operate in that antiseptic fashion. Too often, investors are their own worst enemies because they let their feelings get in the way. Many make wealth-destroying decisions that, after the fact, are all too predictable.

Warren Buffett counsels investors to "be greedy when others are fearful, and fearful when others are greedy." The irony is that many investors do exactly the opposite. In bull markets, ebullient investors convince themselves that rising prices imply that it is a good time to invest. Likewise, frightened investors conclude that the appropriate time to flee financial markets is when prices are falling. When you step back, that kind of thinking makes little sense. What other goods do we buy when prices rise and sell when prices fall?

Some insight into this phenomenon is provided by the field of behavioral finance. Confirmation bias occurs when investors look for information or opinion sources that confirm their beliefs and discount sources that are contrary to their beliefs. Nervous investors will give credence to pundits who suggest markets and individual investments are overvalued, ignoring those who view the world differently. Of course, investors who have a positive view of the markets will do exactly the opposite.

Some pundits make a consistent market in positive or negative opinion. For example, Abby Joseph Cohen of Goldman Sachs is generally bullish on markets while Marc Faber (aka Dr. Doom) is consistently bearish. Investors who look at the markets positively gravitate toward Ms. Cohen, while fearful investors are fans of Mr. Faber.

Many years ago when I was at Creighton University, I taught a class in which students managed real money. When a student presented a buy recommendation on a stock, I would assign another student to present the rationale for selling the stock. Bringing diverse opinions to the table allowed the group to make better decisions and see what could potentially go both right and wrong with certain investment scenarios. When we take a step back, most people recognize that it is instructive to consider diverse opinions when making investment decisions. Singular points of view and following the herd are, after all, is hazardous to one's wealth.

While not in the field of finance, the latest election provides a cautionary tale to the dangers of confirmation bias. Both sides of the political aisle are guilty of accessing news sources that simply confirmed their opinions without considering opposing views. People take great comfort in opinions that support their political worldview and have difficulty considering new information or opinions contrary to that view. In Anchorman 2, the buffoonish Ron Burgundy said, "I just don't know why we have to tell the people what they need to hear. Why can't we just tell them what they want to hear?"

While I am always bullish on the prospects for this great country, I am temporarily disheartened by the worsening political divide. The reaction to the latest election gives me little hope for healing of this growing chasm without a lot of intentional effort on both sides. Many Facebook users are "unfriending" people who are on the opposite side of the political aisle. One certainly does not have to agree with diverse opinions, but discounting them as having no value is close-minded and dangerous. No matter which party -- Republican or Democratic -- had won this election, roughly half of the electorate would have experienced despair and believed that the end was near. We need to break the cycle of confirmation of beliefs, a condition that is as unhealthy for a vibrant, diverse democracy as it is for your investments.

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