The ancient Greek historian, Thucydides, wrote, “It is a habit of mankind . . . to use sovereign reason to thrust aside what they do not fancy.” The phenomenon to which he speaks manifests itself in all walks of life, from politics to religion and investing. Today, this concept is termed “confirmation bias” and refers to the tendency of people to favor information that confirms their beliefs or hypotheses. Research “suggests physiological explanations . . . that the evolutionary development of the human brain has facilitated the ability to use heuristics which provide good judgments quickly, but which can also lead to systematic biases.”1 As financial market participants, we must acknowledge the presence of this bias in order to improve investment performance and avoid unforeseen risks. To this end, it’s worth considering instances of confirmation bias at the investor, banking, and corporate levels.
We submit that confirmation bias is particularly visible at the investor level. The advent and penetration of 24/7 financial news, online investing platforms and stock discussion forums creates a new set of challenges – especially for the individual investor. An academic study examined stock message boards and concluded that confirmation bias not only exists, but is more pronounced for investors with positive and strong beliefs about a stock. Moreover, the study indicates that confirmation bias increases as volatility rises. 2 Said another way, investors look to others for comfort and confirmation when their beliefs are challenged by the market.
While institutional investors may not spend as much time on message boards (as they have greater access to institutional-caliber research), they are not immune to confirmation bias. One of the more obvious sources of confirmation bias is simply in seeking out facts or surrounding oneself with others that support a pre-conceived conclusion. In recognition of this tendency, Warren Buffet invites critics and short-sellers of Berkshire Hathaway to the company’s annual meeting to challenge assumptions and test beliefs.
But there may also be a more worrisome, stealth source of confirmation bias. Author and online organizer Eli Pariser argues that large and influential websites, such as Google and Facebook, use algorithms that utilize unique user data that tend to reinforce a specific user’s current thinking and filters out new ideas. In doing so, Pariser suggests that users are trapped in a “filter bubble” and aren’t exposed to information that could potentially challenge or broaden their viewpoint. As institutional investors utilize online search engines and social media more heavily, they should be cognizant of this potentially insidious problem and take action to avoid falling victim to the filter bubble. According to Eli Pariser, there are “10 Ways to Pop Your Filter Bubble.”
Investors are not the only financial market participants that exhibit confirmation bias. Indeed, the same tendencies are discernible at investment banks, a point that is illustrated when examining the roots of the Global Financial Crisis (GFC). As concluded in a study on confirmation bias and banker compensation, “a desire to appear competent may explain what appear to be the cognitive errors that are known as confirmation bias.” The study also states, “In addition to contributing to the recent excess in financial markets, it is possible that a reward structure that leads to confirmation bias can also cause asset price anomalies.”3 Let us be clear – this is not to say that confirmation bias was the sole cause of the GFC. However, an investor that was conscious of the connection between confirmation bias and compensation structure perhaps would have challenged the bankers’ avoidance of investigating the details of the underlying assets.
In evaluating potential investments, the importance of being able to recognize confirmation bias within corporations, management teams, and board rooms cannot be understated. There have been several high profile corporate miscues in recent years that now serve as case studies in behavioral finance. For instance, Hersh Shefrin, Professor of Finance at Santa Clara University, cites Merrill Lynch’s decisions prior to the GFC as the firm continued to take on more risk in the mortgage market, despite AIG’s refusal to provide insurance due to concerns about the very same market.4 In addition, a study on the behavioral analysis of BP suggests that confirmation bias, among other pitfalls, “exerted strong influences during the Deepwater Horizon explosion.”5
To be sure, identifying confirmation bias at the corporate level is not easy as investors aren’t privy to the daily conversations among employees, executives, and board members, and few investors are able to meet senior management in person. However, investors can improve the prospect of identifying confirmation bias by evaluating ESG factors. Envisage a company in which earnings revisions, price momentum, and management commentary are universally positive, but a poor corporate governance record is uncovered. All else equal, poor governance raises a red flag and highlights the need for further research. While such analysis does not eliminate the potential for confirmation bias, it can reduce the impact of it.
Michael Shavel, CFA, is the Research & Business Analyst at Cornerstone Capital Inc. and a former Research Analyst at AllianceBernstein’s Global Growth and Thematic team.
1 Sabourian, H. and Sibert, Anne C., Banker Compensation and Confirmation Bias (April 2009), CEPR Discussion Paper No. DP7263,
2 Park, J., Prabhudev, K., Gu, B., Kumar, A., Raghunathan, R., Confirmation Bias, Overconfidence, and Investment Performance: Evidence from Stock Message Boards (July 2010), McCombs Research Paper Series No. IROM-07-10
3 Sabourian, H. and Sibert, Anne C., Banker Compensation and Confirmation Bias, pg. 25-26
4 Shefrin, Hersh, 2008. Ending the Management Illusion. New York: McGraw-Hill.
5 Shefrin, Hersh and Cervellati, Enrico Maria, BP’s Failure to Debias: Underscoring the Importance of Behavioral Corporate Finance (March 29, 2011). SCU Leavey School of Business Research Paper No. 11-05