Confirmation bias in trading

Confirmation bias in trading

What is confirmation bias?

Confirmation bias is a cognitive bias that refers to the tendency of individuals to interpret or search for information in a way that confirms their preexisting beliefs or hypotheses while disregarding or downplaying conflicting evidence.

In other words, we search for information that confirms our beliefs.

Confirmation bias can manifest in various ways. For instance, someone might selectively expose themselves to news sources, articles, or social media posts that align with their opinions, while avoiding or dismissing sources that present alternative perspectives.

When confronted with contradictory information, individuals may unconsciously reinterpret or reinterpret it in a way that aligns with their existing beliefs.

There are a few reasons why confirmation bias occurs.

First, it provides psychological comfort by reinforcing one’s sense of identity and belonging to a particular group or ideology.

It can also serve as a defense mechanism against cognitive dissonance, the uncomfortable feeling that arises when holding conflicting beliefs.

Additionally, confirmation bias can be a result of cognitive efficiency, as it requires less mental effort to process information that is consistent with existing beliefs rather than critically evaluating new or contradictory information.

Confirmation bias can have several negative consequences.

It can lead to the perpetuation of misinformation and the spread of rumors, as people are more likely to accept and share information that confirms their existing beliefs without critically evaluating its accuracy.

It can also hinder rational decision-making by preventing individuals from considering alternative viewpoints and evidence that may lead to better outcomes.

For example:

When you go online and search for “why milk is harmful”, you’re essentially seeking evidence to support your existing belief that milk is detrimental to your health. However, it’s important to note that this approach is not an appropriate or unbiased way of seeking information.

If you hold the belief that milk is harmful to your health, it would be more appropriate to actively seek out reasons why it might actually be beneficial for you. In doing so, you can explore the opposite perspective and consider information that challenges your initial belief.

The main point is that when you search for the negative aspects of milk, you will only discover information about its detrimental effects, without ever exploring the positive aspects of milk.

A person following a vegan lifestyle searches the internet to explore the detrimental effects of consuming meat on one’s health.

That’s a bad practice.

The recommended action is to actively seek out reasons that challenge or contradict your existing beliefs.

If you wish to eliminate milk from your diet, it is advisable to search for reasons why milk is beneficial for you instead of focusing solely on its negative aspects. By exploring information that contradicts your initial belief, you open the possibility of reassessing your beliefs if compelling evidence suggests that they may be incorrect.

How confirmation bias affects trading?

1. Selective information processing

Traders affected by confirmation bias may seek out and give more weight to information that supports their preconceived notions about trade while ignoring or downplaying information that contradicts their beliefs. This can lead to an incomplete or skewed assessment of the market conditions and potential risks.

2. Overconfidence

Confirmation bias can fuel overconfidence in traders. When they find information that supports their initial trading decisions, they may become overly confident in the correctness of their analysis, leading to increased risk-taking without considering alternative viewpoints or potential pitfalls.

3. Ignoring contradictory signals

Traders influenced by confirmation bias may dismiss or rationalize contradictory signals in the market. They may stick to their initial position even when market trends or indicators suggest otherwise, leading to missed opportunities or holding onto losing trades for too long.

4. Lack of adaptability

Confirmation bias can make traders resistant to changing their views or adapting their strategies based on new information. They may become emotionally attached to their initial beliefs, making it difficult to objectively evaluate the evolving market conditions and adjust their positions accordingly.

For example:

Upon examining a stock and briefly reviewing its chart, you may already form a rough notion of its potential trajectory. However, this carries inherent dangers since once you adopt that belief, confirmation bias will prompt you to seek out justifications that validate your initial viewpoint.

The challenge with trading lies in the fact that for any given stock, you can discover multiple reasons to expect its upward movement as well as numerous reasons to consider shorting the same stock.

The key approach is not to form a belief and then seek evidence to support it. Instead, it is more effective to adopt a belief and actively seek out evidence that contradicts it.

If you believe a stock is likely to rise, make an effort to find reasons why it might not experience an upward movement.

Confirmation bias not only impacts our tendency to value information that aligns with our existing beliefs, but it also leads us to downplay the significance of new information, which should ideally be given more weight.

This interaction between confirmation bias and the anchoring effect further reinforces our biases and hinders us from fully considering and incorporating new information into our decision-making process.

It is important to assign greater significance to information that challenges or discredits our beliefs while allocating less weight to information that supports or confirms our existing beliefs.

To mitigate the impact of confirmation bias on trading, it is essential for traders to remain aware of this cognitive bias and actively seek out diverse perspectives, alternative viewpoints, and contradictory evidence.

Engaging in thorough research, considering different sources of information, and regularly evaluating one’s own biases can help traders make more informed and objective decisions.

When new information emerges that discredits our existing belief, it is crucial to be willing to change that belief rather than persistently seeking additional reasons to support our initial stance.

The ability to adapt and adjust our beliefs based on new information is essential.