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The Problem with Confirmation Bias

April 3, 2010 Leave a comment

Confirmation bias is endemic to financial markets because their participants have money on the line and those participants want to know that the bets they are making will be profitable. Therefore, investors, traders, financiers, and all other manner of market participant seek reassurance. This type of cognitive bias makes an appearance in other places, and it’s useful to consider how it harms those unaware of it.

The New York Times has an interesting article about Tiger Woods, his inner circle, and the loyalty he demands from the same:

Tiger Woods, a self-acknowledged control freak, insists on loyalty as a fundamental quality in employees, associates and friends. Just how much Woods values allegiance was summed up by his father, Earl, in an interview shortly before he died.

“Loyalty is No. 1 to Tiger,” Earl Woods said in a biography of his son. “You’re loyal or you’re history.”

The problem here is a lack of perspective. If all the people with whom you deal hew to the party line you have no way of understanding perspectives different from your own experience. (North Korea’s cult of personality is probably the most extreme demonstration of this cognitive bias.)

How does this type of bias manifest itself in finance? The always-invaluable Robin Hanson at Overcoming Bias writes:

We’d love for things to go well. So we’d love people to think that things are going well. So we want folks to hear news about how things are going well. But sometimes people hear bad news, about how things are going bad. Gee – why don’t we fix this by banning bad news? Then people will only hear good things, and so only good things will happen, right?

This argument is transparently stupid to most everyone, at least when they think of “bad news” as appearing in newspapers or TV shows. Sadly, that insight seems to disappear when it comes to financial bad news communicated via short sales.

Just as Tiger Woods seems to want to avoid any appearance of discord or disagreement within his empire, and so has suffered as a result, financial market players don’t want to contemplate news that doesn’t comport with their view of the world. It is likely true that most investors are a rather optimistic lot–else, why bet on the future outcome of an investment–and so don’t want to contemplate that maybe the future is not as rosy as the conventional wisdom.