Confirmation Bias in Investing: Seeing Only What You Want to See
Francis Bacon said it centuries ago: humans are “more moved and excited by affirmatives than by negatives.” Chapter 6 of Pompian’s book is about confirmation bias, and honestly, this might be the most dangerous bias in the whole book.
The Basic Idea
Confirmation bias is your brain’s search engine, but with a broken filter. You only see results that confirm what you already believe. Everything that contradicts your belief gets automatically buried on page 47 of the results where nobody ever looks.
Pompian gives a simple everyday example. You buy a TV. Then you go to a store that you know has higher prices just to see that your TV costs more there. You do this to confirm that you got a good deal. You are not actually looking for information. You are looking for validation.
We all do this. The problem is when we do it with our money.
The Card Experiment
There is a classic experiment that shows how deeply wired this bias is.
Four cards are placed on a table. Each card has a letter on one side and a number on the other. You can see: A, K, 2, 9. The rule is: “If a card has a vowel on one side, it must have an even number on the other side.”
Which two cards do you flip to test this rule?
Most people say “A” and “2.” But here’s the problem. Flipping the “2” cannot disprove the rule. Even if there is a vowel on the other side, all it does is confirm the rule. To actually test the rule, you need to flip the “9” because finding a vowel behind it would break the rule.
People pick “2” because they want to confirm the hypothesis. They don’t pick “9” because they don’t want to disprove it.
And here’s what really got me. The subjects in this experiment had no reason to care about whether the hypothesis was true or false. They just heard it 30 seconds ago. But they immediately started trying to confirm it rather than test it.
That is how deeply wired this bias is. Your brain adopts beliefs almost instantly and then starts defending them.
The IBM Disaster
Pompian tells a great cautionary tale from the early 1990s. IBM employees were convinced their company’s OS/2 operating system would become the industry standard. They loaded up on IBM stock.
Meanwhile, Microsoft Windows was clearly becoming the dominant product. But IBM employees ignored this. They focused on every tiny positive sign that OS/2 was making a comeback. They sought confirmation. They avoided contradiction.
IBM stock went from $35 to $10. It took five years to recover. Some employees delayed retirement. Many got laid off during the restructuring.
This is confirmation bias with real consequences. These people worked at the company. They had more information than outside investors. But having more information did not help because they only processed the information that confirmed their existing belief.
I spent decades working in IT. I watched similar things happen with other technologies. Engineers and managers convinced their platform was the winner, ignoring clear signals from the market. The pattern repeats because the bias is the same.
The Poker Analogy
Pompian uses a poker example that I think is very effective. You get three kings on the flop. You are so excited about your hand that you stop paying attention to the board. Hearts keep appearing. You don’t notice because your cards are telling you “I can’t lose.” Then someone shows a flush and takes your money.
You were only listening to information that confirmed your belief (three kings = winning hand). You ignored information that contradicted it (hearts accumulating on the board).
In investing, the “hearts on the board” are the warning signs. And confirmation bias makes you blind to them.
Four Ways This Hurts Investors
Only seeking confirming information. You buy a stock and then only read bullish analysis. You avoid any article that is negative about the company. You literally curate your information diet to exclude anything that might make you uncomfortable.
Over-relying on preset screens. Some investors only buy stocks that break through 52-week highs because they believe in that signal. They ignore fundamental analysis that might say the stock is overvalued at that price. The screen confirms their bias, so they follow it blindly.
Overloading on company stock. Employees hear positive buzz at work and load up on employer stock. They dismiss negative news. Enron, WorldCom, Lehman Brothers, Bear Stearns. How many times does this lesson need to repeat?
Holding underdiversified portfolios. People fall in love with a stock and keep buying more over the years. They build a huge concentrated position. They don’t want to hear anything negative about it. They actively seek out only positive information.
The P/E Ratio Myth
The research section of this chapter is really good. Professors Statman and Fisher tested the common belief that P/E ratios can predict stock returns. Many investors believe high P/E means sell and low P/E means buy.
Statman and Fisher examined 128 years of data from 1872 to 1999. They built a simple 2x2 table. Does high dividend yield predict high returns? Does low P/E predict high returns?
The results were clear. The confirming evidence (high yield followed by high returns, low yield followed by low returns) was almost exactly equal to the disconfirming evidence. It was basically a coin flip.
But investors who believe in P/E-based timing only remember the times it worked. They forget the times it didn’t. That is confirmation bias in its purest form. You remember the hits and forget the misses.
What To Do About It
Pompian’s advice boils down to one thing: actively seek out information that contradicts your investment thesis.
This feels unnatural. It feels uncomfortable. That is exactly why most people don’t do it.
But here’s the thing. Finding contradictory evidence doesn’t necessarily mean your investment is bad. It means you have a complete picture. You can still hold the stock if the evidence supports it. But now you are making an informed decision instead of a biased one.
For company stock, monitor negative press about your employer. Research competitors. If there’s smoke, there is often fire.
For concentrated positions, force yourself to list reasons why the stock might go down. If you can’t think of any, that is not because there are none. It is because confirmation bias is blocking them.
The hardest thing in investing is not finding good ideas. It is being honest with yourself about the bad ones.
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This is part of a series retelling “Behavioral Finance and Wealth Management” by Michael M. Pompian. Start from the beginning.