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Chapter 2 Confirmation Bias

Confirmation bias is the tendency to search for, interpret, favor, and recall information that support one’s own decision and assign a lot less weight to information that does not. This can lead to a serious problem more so in trading, as it leads traders to become complacent in the position initiated and maintain their trade well after it should have be closed.

A consumer who likes a particular brand and researches for a new purchase may be motivated to seek out customer reviews over the internet that favors that brand, thereby being biased towards the brand right from the start.

Confirmation Bias in financial markets

Confirmation bias occurs when traders take a position in the markets and then focus mainly on the technical indicators or market news that supports staying with his position. Many traders find a company they like and then tend to become its #1 fan. They only look for news and press releases that support their positive image of that company. Any fundamental or technical warning sign is not taken into consideration and the information is squashed.

Generally in such cases the trader does not stick to his trading plan and throws caution to the wind by not maintaining a fixed stop loss in his trade.

In the above chart of CEAT Ltd a trader analyses the chart and concludes that the price will go up. From that point onwards, the trader will only look for confirmation of a bullish price trend. Every indicator or price pattern he finds will be viewed and interpreted to confirm his view: price should go up. Any indication that the price might do the opposite will be mostly ignored.

The stock gives a clear technical breakdown from an ascending triangle formation with a huge surge in volumes on the day of its result day as well as the fundamental data was not justifying the steep surge in prices of the stock of late. The stock had rallied 123% in the last 2 years with its profit margins shrinking from 15.3% to 3.7% respectively.

Still due to confirmation bias there would be traders not maintaining a stop loss and holding on to the stock hoping it would bounce back, but the stock goes on to correct ~ 20% in the next 5 days and could correct more.

Overcoming confirmation bias

Confirmation bias is a source of trader overconfidence in the markets and helps explain why bulls tend to remain bullish and bears tend to remain bearish regardless of what is actually happening in the market. Confirmation bias helps explain why some traders do not always behave rationally. However, an investor who is aware of confirmation bias may be able to overcome the tendency to seek out information that supports his existing opinions and intentionally seek out contradictory advice.

There's a lesson here for all of us - to avoid making bad decisions about investments and many other topics we must do two things:

  • Be aware of the danger of confirmation bias, and acknowledge that our judgment can be clouded by it.

  • Aggressively seek out and understand information that disagrees with our existing belief.

The second step may involve talking to people who don't share our opinion, and listening to their reasoning rather than arguing our own point. It could be as simple as reading some of these opposing views. Regardless, it's important to evaluate the information as rationally as possible and avoid one's impulse to explain why it's wrong

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