Confirmation bias. Can Elliot waves reveal sacred signals to achieve your financial goals?
Confirmation bias is a cognitive bias where people favor information that supports their beliefs and ignore contradictory evidence. It leads to overly confident and concentrated investment decisions. To mitigate its consequences, investors should consider alternative views, diversify their portfolios, avoid excessive reliance on specific sources or techniques, and incorporate all relevant information for a balanced risk management approach. Discover whether you are prone to a confirmation bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.
Behavioural science. What is confirmation bias?
Confirmation bias is a behavioural pattern whereby a person tends to overvalue facts confirming his beliefs and devalue those that contradict them. It also leads people to actively seek and collect evidence bolstering their claims or trade ideas. This bias is quite common among investors.
Confirmation bias is a cognitive bias, i.e., a mistake in decision-making. These biases can be effectively corrected with education.
What are the consequences, and what can I do?
Quite often, investors read almost exclusively the market analysts that share their positive opinions on their stocks. History shows that these investors will likely become seriously disappointed at some point. A wiser strategy would be to read all the risk analyses, including supporting and negative views.
Similarly, many investors tend to invest excessively in their employers’ stocks, motivated by what they hear daily at work about how their employer is about to beat its competitors.
Confirmation bias tends to produce heavily concentrated portfolios as investors become overly confident in their investment decisions. If a particular position exceeds 10% of your portfolio, it is wise to revisit the analytical grounds and consider alternative views on your portfolio risk.
The modern manifestation of this bias is investor websites. At any moment, there are several darling stocks, and naysayers who express alternative opinions risk being heavily bullied. Behavioural finance confirmation bias pushes the users who bought these stocks to actively devalue views that contradict their beliefs. This explains the numerous dramatic increases and subsequent drastic falls of many ‘meme’ stocks. It is wise not to rely on the opinions of such bullies, as they are very likely to be influenced by confirmation bias and unaware of all embedded risks. There are few good examples of good ‘meme’ stock investing, so you should take great care when drawing upon ideas from investor websites or other collective-mind sources in your asset allocation process.
Another widespread example of confirmation bias is excessive or blind reliance on technical analysis. Some investors tend to make investment decisions based on Elliot waves or Fibonacci retracements, for example. These investors believe in these tools, and many public stories seemingly confirm the incredible power of these technical patterns. However, when other vital pieces of information, such as companies’ fundamentals, are ignored, any approach, including technical analysis, is more likely to disappoint than generate consistent returns in the long run. A wiser risk management strategy would be to take every other piece of information, confirming and disproving your view, into account.