Unravelling confirmation bias

When making financial decisions, investors often grapple with a subtle but potent force that can shape the outcome — confirmation bias. This cognitive tendency, deeply rooted in human psychology, has profound implications for investment strategies and other financial choices.

Confirmation bias, simply put, is the tendency to seek, favour and remember information that aligns with pre-existing beliefs while dismissing contradictory evidence. Its allure lies in the sense of validation. The desire to be right leads investors to cherry-pick data that supports their views. While understandable, it can create a false hope in less-than-ideal investment options.

Consider an investor evaluating a revenue-generating property. Fuelled by the prospects of passive income and the lucrative returns of short-term rentals, initial enthusiasm can lead to a cascade of justifications. The expected high rental rate more than pays for the borrowing costs, leaving a handsome profit. Positive market trends and success stories come readily to mind, reinforcing the belief that the purchase is a sure success.

Sometime later, however, unforeseen challenges emerge. It isn’t easy to get cleaning services. Maintenance costs are higher than expected, and rentals aren’t booked as often as anticipated. Then, a new law prohibiting short-term rentals is introduced, and long-term rental rates won’t turn a profit. Finally, the sobering reality of transaction costs and price uncertainty when selling the property comes too late.

Confirmation bias can influence investors of all asset classes—from housing to stocks to bonds. It can also influence financial choices such as selecting one mortgage interest rate term over another.

To limit the effect of confirmation bias, investors must adopt habits to counteract this silent persuasion. A pros and cons list (with an emphasis on the cons) is a potent tool to consider alternative, and sometimes unpleasant, outcomes. The goal is not self-flagellation but making better financial decisions through scrutiny.

Checklists and decision trees are other basic strategies to ensure you don’t rush into a decision before considering what could go wrong. A checklist itemizes steps or considerations before making a final decision. A decision tree is a path to follow given the information gathered along the process.

Returning to the income property example above, you could create a checklist of a home’s components that deteriorate over time to help determine a property’s maintenance costs. This checklist could be part of a decision tree to determine the expected cashflows and profit from the investment, and whether it meets your criteria. Automating these steps in your process will further reduce the potential for bias because you’ll be less likely to skip a step.

Financial decisions driven by the desire to validate preconceived notions can lead you to overlook crucial factors. Investors convinced of a particular venture’s profitability become naturally attuned to supportive details, dismissing contradictory data and potential pitfalls. Using tools that force you to reframe your perspective and question assumptions will improve decisions.

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