You’ve probably heard a family member or a colleague complain about someone who “hears only what he wants to hear.” While being wedded to one’s opinions and ignoring new, relevant information is human nature, this trait can seriously jeopardize investment decisions. In fact, in the world of behavioral finance, ignoring information that could challenge an opinion you already hold has a name–confirmation bias. When we selectively filter information and focus only on data that supports our current opinions, we lose perspective and are prone to make poor investment decisions. In fact, studies show that even professional fund managers are more likely to accept information that supports their original investment thesis than they are to search for information that contradicts their views.
How does confirmation bias affect your decision making? Think of times a stock you purchased fell in value, yet you remained convinced of its long-term viability. How long did you hang on, expecting it to recover, before you cut your losses? Consider, too, how many investors believe they should only invest in dividend paying stocks. When they see a magazine headline promoting the benefits of dividends, they buy the magazine and read the article to support what they believe. Because they don’t consider the fact that many of today’s dividend paying stocks were not dividend payers earlier because of their startup nature is absent from their decision making process. They don’t consider that selecting only dividend paying stocks over the last few decades would have deprived their portfolios of the returns of companies like Cisco, Kohl’s Oracle, St. Jude Medical, and Starbucks in their early days. Take these factors into consideration and it’s likely an investor will embrace a broadly diversified strategy that includes both dividend payers and non-dividend payers and enjoy the potential rewards of both.
As Benjamin Graham said, “The investor’s chief problem–and even his worst enemy–is likely to be himself.” So, be mindful of your behavioral tendencies and keep an open mind. Increased self-awareness can lead directly to better investment decisions.