Your clients could be letting their existing beliefs get in the way of clear decision-making when it comes to investments. Nick Armet, investment director at Fidelity Worldwide Investment, explains how you can help them avoid ‘confirmation bias’:
It is often said that “seeing is believing”, but behavioural finance tells us that when we make decisions under uncertainty, the picture we ‘see’ is not always reliable. Views about the future behaviour of investment markets can be heavily influenced by the information we choose to focus on and by the decisions we have previously made.
Confirmation bias describes our tendency to interpret evidence in ways that are partial to our existing beliefs. Once we make up our minds, we are prone to look for evidence that agrees with our view. In everyday life, and in relationships, it’s generally a good aspect of human nature that we look for positive affirmation of our most difficult decisions. Not so in investment, where the decision to own an asset, a market or a stock should be regularly reviewed in the most dispassionate terms.
This bias is a pernicious problem for investors. Investment bulletin boards are full of people with the access to broadly the same information but diametrically opposite views. Some of them have bought and are looking for reasons to confirm their decision, while some of them have sold and want confirmation they did the right thing. What behavioural finance tells us is that our actions and beliefs have a strong impact on our subsequent decision making.
This can leave investors clinging to an investment decision or view long after the original analysis was done, despite the fact conditions may have changed. For instance, in the years since the financial crisis, investors have sought safe havens running down equity allocations to historically low levels; the good subsequent performance of safe havens like US treasuries will have helped to justify this stance. In reality, despite all the uncertainty in markets, riskier assets such as equities have also performed well, albeit with more volatility. In this way, confirmation bias can inhibit our consideration of other assets and cloud our ability to recognise market turning points.
So, what can investors do to avoid the immobilising effects of confirmation bias? In his philosophy of scientific technique, Karl Popper believed that the only way of testing a view was to deliberately look for all the information that disagrees with it. In investment terms, this means it is essential to actively seek dissent, surround yourself with opposing views and test your assumptions with those who hold different opinions. It also means being aware of the information you consume and which factors you give most weight to in your decision-making. If your established view is a consensus one, you should always be prepared to embrace the contrarian view and the possibility that you (and the rest of the crowd) could be wrong.
Have a well-defined sell strategy: Before you buy, be clear about what would cause you to change your view. If any of those events come to pass, it makes it easier to act appropriately.
Try estimating the odds that your view is wrong: Professional investors regularly use scenario planning and attach weights to different outcomes based on their research conclusions. If you believe there is a 20% chance of an adverse outcome, you have to accept you will be wrong, at least, once in five times.
Invest in multi asset solutions run by asset allocation specialists: The emotion involved in having to sell one loved asset for an unloved asset is removed and outsourced to a professional with a rigorous investment process and access to a wide range of research views.
Interestingly, despite the obvious benefits of diversification, research suggests that most investors do not hold diversified portfolios. Instead, they rely heavily on investing in a handful of select assets and run the risk of not reviewing their investments as conditions change. Given the emotional traps that behavioural finance suggests can paralyse our decision making, multi-asset funds can offer a practical and increasingly popular solution for many investors.
Whenever a range of outcomes is possible, it is dangerous to become fixated on a particular scenario, however convincing the arguments. When a wide range of investors buy into a compelling idea, the necessary conditions for a bubble have often been laid, which can ultimately have negative consequences for those investors who fail to challenge and, if necessary, reassess their investment stance.