Confirmation Bias and Your Money

Over the last few weeks, I’ve been involved in a very interesting discussion with a reader who wanted to know why I thought index funds were such a great investment strategy. I pulled out a huge array of quotes and experts that support my claim. A sampling:

Deep down, I remain absolutely confident that the vast majority of American families will be well served by owning their equity holdings in an all-U.S. stock-market index portfolio and holding their bonds in an all-U.S. bond-market index portfolio… The rationale for a 100-percent index fund portfolio remains as solid as a rock. It’s all about common sense.John Bogle

For many investors, especially those who prefer an easy, low-risk solution to investing, I recommend bowing to the wisdom of the market and using index funds for the entire investment portfolio. For all investors, however, I recommend that at least a portion of the investment portfolio – especially the retirement portion – be invested in index funds.Burton Malkiel

Clearly, the best way to avoid [overpriced and underperforming mutual funds] is to simply keep your expenses to a minimum and buy the whole market with an index fund.William Bernstein

[A]t least in your 401(k), you’re better off investing in an index fund with low costs that simply tries to mimic the performance of the entire market than in a mutual fund that tries to beat the marketJim Cramer (!?)

I’ve made my case, right? Not so fast. The reader was able to respond with at least as many examples of individuals touting the value of investing in individual stocks. He had tons of research and information advocating individual stock picking and tons of great examples of how it works.

In the end, we agreed to disagree. We each had a pile of information that reinforced what we already knew and decided to leave it at that.

This is a very clear example of confirmation bias – it’s easy to find and accept evidence for what you already believe, but very hard to find and accept evidence that contradicts what you already believe.

Here’s another example that came into play during our car search. Based on my own personal experience and on anecdotes from the experiences of others, I have a bias when it comes to car manufacturers in terms of reliability and bang for the buck. I tend to, if anything, overvalue Honda and Toyota and undervalue Chrysler/Dodge, General Motors, and Ford. Time and time again, I’ve witnessed cars from the big three failing just over the 100,000 mark, while I’ve witnessed several Hondas and Toyotas still going strong over the 300,000 mark without huge repairs. I’ve also read a pile of Consumer Reports car issues and Honda and Toyota are consistently at the top of their reliability rankings.

That information is in line with many of the anecdotes and studies that I read, but it goes further than that. I tend not to trust articles that contradict that idea. I do tend to believe anecdotes that report poor reliability in Hondas and Toyotas and great reliability and value in GMs and Fords and Chryslers, but I view them as outliers – exceptions to the rule.

I recognize that I have these biases. I prefer Hondas and Toyotas to cars from the big three on reliability and long-term value and I prefer index funds to individual stocks for long term investing goals.

What’s interesting, though, is that I tend to view research and quotes that support those biases as being more valid than those that oppose those biases. That’s pure confirmation bias – I’m biased towards sources that confirm what I already “know.”

Another angle: I had a very strong confirmation bias towards used cars. I believed that buying used was an absolute rule if you want to find a bargain, and for most of the year we spent looking for our car, I didn’t even bother to look at new cars. It was only when I was repeatedly bashed in the head with evidence (from Consumer Reports, for starters, and from many other sources) that under current economic conditions there are better bargains for new purchases if you’re going to drive the car into the ground that I bothered to actually start including new cars in our comparisons. In the end, we wound up buying new, but only after running the numbers until our spreadsheets begged for mercy.

Obviously, confirmation bias isn’t a good thing. It blinds you to changes and opportunities. For example, in the last few years, Ford’s bang for the buck and reliability have really turned around. I consciously know this, but if I’m looking at a Honda and a Ford, I still tend to trust the Honda. Another example: I’m fairly good at picking individual stocks that do quite well – and I prove it to myself time and time again with Google Finance test portfolios. The returns exceed what I’m getting with my index funds. So why don’t I switch? It’s simple – my confirmation bias kicks in and I view my own performance as an outlier – a fluke.

We all have these biases. It’s part of human nature and, quite often, it serves us well. It keeps us focused on what’s important.

Having said that, it’s dangerous to simply avoid contradicting opinions. The healthiest thing a thinking person can do is to consistently read articles and sources of information that contradict what he or she knows – and then see whether or not the arguments being presented actually have merit or not. This is why I read books by Jim Cramer on individual stock investing. This is why I extensively research individual auto purchases. It’s also why I read books by atheists and socialists – they challenge my thinking.

The more you challenge your biases, the more likely you are to find the best answer for your situation – and that best answer will often put money in your pocket and help you find the best value.

So I’ll ask you: sit back and think for a minute. Can you name a bias that you have? Now, go out there and challenge that bias. Check out a new bank. Try a new supermarket. Compare the real numbers, not your preconceived notions. Even if you simply confirm what you already know, you’ll find yourself understanding your own choices better, whether it’s a choice to use your local bank or a choice to use your preferred supermarket.

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46 thoughts on “Confirmation Bias and Your Money

  1. George says:

    I can think of two biases I have: living west of the Rockies is terrible and Oregon’s income tax with no sales tax is better for the residents than Washington’s sales tax with no income tax.

  2. Michael says:

    It seems like I read this site to overcome my confirmation bias. :(

    I’ll just say that the reader who said active stock picking works is probably insulted that you read Jim Cramer to understand his argument. No, it’s not me.

  3. Excellent excellent article! Another one of your gems. It got me started into identifying what cobwebs I need to clear up from my mind.

  4. Baker @ ManVsDebt says:

    Another thought-provoking topic! My biggest bias would have to come in the debate on whether to use credit card responsibility or whether to eliminate them from your life altogether.

    Currently, we are enjoying the many benefits that come with simply eliminating them from our lives. However, I can easily understand someone whom may choose to utilize them, as long as they are creating restrictions to minimize any additional spending and/or hassles. I can see intelligent reasons for both sides, even though often times people can only see the benefit of their side.

    Great read!

  5. leslie says:

    Oh i’m just stubborn. I don’t even need facts to back up my biases, I’ll believe them no matter what.

    I have changed several of these…. it just took a very long time :)

  6. Mike C says:

    I have an argument that I really like about index funds. Index funds guarantee that you earn the market average. This is a guaranteed mathematical fact. Now, any other strategy will earn either more or less than the market average. It’s easy to see that the people that invest in a strategy that earns more than the market average do it because the expect to beat the market.

    But then, why would anybody invest in a strategy that yields less than the average? The answer is simple, because they too think that their strategy will beat the market.

    So if you are going to use a strategy different from an index fund, you should seriously ask yourself: what do I know that the rest of the market does not know that will make this strategy beat the average? If the answer is “nothing”, forget about it and put your money in an index fund.

  7. beth says:

    This argument goes quite well with the food debate that’s been going on since Friday’s post too. Those of us who insist that organic always tastes better will use every argument that comes up for our cause (I’m as guilty as anyone), but will dismiss the negatives as one-offs or simple side effects. The same way that you might be convinced that that tomato off the vine in your back yard tastes so much better than one at the store, but seeing as how I *hate* tomatoes (in any non-pureed and spiced form), I would always be biased that the ones from the store are just fine.

    Food, finances, “why do I always date the same kind of guy”– I think we could look in to this one from any angle.

  8. JF says:

    I don’t have any biases when it comes to investing because I use a mechanical approach. Emotion is never involved in my decisions, just math.

  9. Trent says:

    “I’ll just say that the reader who said active stock picking works is probably insulted that you read Jim Cramer to understand his argument. No, it’s not me.”

    Someone who would be insulted by that comment isn’t well-read at all – they’ve solely judged Cramer by his clown-like appearances on CNBC. His long-form writings, particularly “Real Money,” espouse a thorough (and surprisingly conservative) individual stock investing strategy.

  10. Michele says:

    Very interesting article. Of course we all have biases based on where we’re from, how we grow up, the color of our skin, etc. I love to be able to discuss issues intelligently with someone who disagrees with me, as long as we can do so without getting into a heated argument.

  11. Tim says:

    Trent, I’ve actually been wanting to read books by atheists for this very reason – to challenge my faith. Would you mind telling me some good books to check out that you have read by atheists?

    Thanks!
    Tim

  12. Michael says:

    Trent, I’ve read Cramer. I also read a lot of interviews with successful investors. They recommend some of the books you have reviewed, but not any of his.

  13. 444 says:

    “The healthiest thing a thinking person can do is to consistently read articles and sources of information that contradict what he or she knows – and then see whether or not the arguments being presented actually have merit or not.”

    Wow – this is what I do all the time. Thanks for confirming that I’m not just weird, but actually doing something I should be doing. I get a little neurotic about it, thus the suspicion that I might be a little weird.

    But I’m afraid I may miss out on learning something, so I tend to be a voracious reader and overzealous researcher. I seek out reports that conflict with my beliefs and go over them with a fine-toothed comb before I go back to believing what I originally believed (if my belief still holds up, in my opinion, after all that information-gathering/opinion-reading.)

  14. tony says:

    Tim-

    If you are looking for a very thoughtful book by an atheist that will challenge you, try “Atheist Universe: The Thinking Person’s Answer to Christian Fundamentalism.” It’s a good view of atheists written for people who are familiar with Christianity. It’s well written and fairly witty.

    If you try books like “The God Delusion” by Dawkins, he may come off as hostile, and you may find yourself closing yourself off from considering his arguments.

  15. Mike says:

    With hindsight being 20/20 its pretty easy for someone to sell individual stock investing as a good idea. My biggest take away from Bogle’s “Enough” is that the future is 100% unpredictable and individual stock picking is always based on historical data analysis. At least index investing guarantees a market average- even if its an “average” loss…

    Great post and really gets me thinking.

  16. Trent says:

    “Trent, I’ve read Cramer. I also read a lot of interviews with successful investors. They recommend some of the books you have reviewed, but not any of his.”

    Do you not see confirmation bias here?

  17. Michael says:

    Why would I read what made unsuccessful investors into what they are today? How is a bias toward the books that form investors with outstanding returns a bad thing?

    This isn’t me thinking trading a certain way *should* work and reading the books that support that. This is me seeing who can trade, and then learning what made them that way.

  18. Johanna says:

    “Why would I read what made unsuccessful investors into what they are today? How is a bias toward the books that form investors with outstanding returns a bad thing?”

    I would think that reading about the strategies of unsuccessful investors (along with the strategies of successful investors) is exactly what you *would* want to do – because if the successful and the unsuccessful investors turned out to be using the same strategy, then maybe the strategy’s not all it’s cracked up to be, and the successful investors just got lucky.

  19. almost there says:

    Tim, #11. Sign up for email from the skeptic society at skeptic “dot” com. YOu will get plenty of info. Click on their “Reading Room”.

  20. Bill in Houston says:

    We all have biases. I have biases toward strawberry instead of vanilla shakes, Japanese cars over American company cars, redheaded Texans like my wife, Mediterranean food over French food, and so on and so forth.

  21. Amy says:

    I have the exact same bias about cars! My car is a 95 Honda Civic. I bought it a few years ago when it was in need of major repairs. I repaired it myself and it has run great ever since. It only had the issue with it because the previous owner was careless in her care of the car.

  22. Trent, this is a great article. We studied confirmation bias in our sociology class and I found it to be quite interesting. It is important to challenge our beliefs on a regular basis. By doing so, we grow as individuals. We learn a different perspective which may change our opinion or reinforce our own beliefs. Either way, so long as we are keeping an open mind and learning, we are gaining something.

    Check out my article called “Do You See What I See” for more on this topic!

  23. Jerryb says:

    Very few of us in the real world have time to actively manage our portfolios. I leave most of it up to the experts by using index and target date funds for my 401k and Roth IRA.

  24. Keith@bewealthygethappy says:

    Trent, this is a great post – I see this everyday in my own life and interactions. I’m curious, how have you seen this outside of your studying of frugality? I’ve noticed that some of my blog readers are affected by this – I was discussing just this thing at work today when one of my coworkers said I was missing a retirement discussion on my site, and that it was a big gap. He didn’t understand that I don’t like calling it retirement, because the connotation there is a life that I would find boring.

  25. SP says:

    Trent – I’m glad to see you participating a bit in the comments where you feel it adds. It really does make the blog more personal, though I do respect your desire to limit it to where you feel it is most appropriate.

  26. Sometimes new information calls for new decisions– keep your mind open.

  27. Katie says:

    Michael – Have you actually read Cramer’s earlier books? They are quite conservative, and he notes when he did something crazy and tells individual investors that they shouldn’t do things like that. His writings on his website are also much calmer than his show. His book is used as a primer because it’s a really straight-forward introduction to investing and stock-picking. It gets right to the point and it’s not full of antics.

    Finally, the guy is pretty darn wealthy, so he must have done something right, even if it was incredibly risky. You don’t have to like him to realize that and to acknowledge that his earlier books are good introductory material to the world of finance.

  28. Kate says:

    Great article. I think it’s wise to read other viewpoints and ideas. I’ve been picking stocks for years – lately rather unsuccessfully, so I just bought my first index fund last week. Thanks for sharing your ideas.

  29. Randy says:

    So Trent, now that you’ve admitted to having a confirmation bias toward indexing, do you still dismiss an investing strategy that employs more selective determinations of what and when to buy or sell?

    I’ve read Cramer, Malkiel, and others on both sides of the aisle. I’m also a stockbroker at an online brokerage firm. I’ve seen plenty of folks prudently navigate their way to above-market returns picking individual stocks and incorporating options, bonds, and ETFs in an effective way. These folks had the time, inclination, and knowledge of the marketplace needed to make this strategy successful.

    The point being, indexing is not right for everyone. I’ll agree that loaded mutual funds are a rip, and anyone would be better off indexing than paying a fund manager. And for the average investor, indexing is the way to go when the time is just not there to adequately employ a more selective strategy.

    But for those that have the resources and the savvy, indexing should not be a roadblock to better returns, especially in a volatile bear market where index funds got destroyed.

  30. Matt says:

    I’m surprised no one has put “confirmation bias” as the leading cause as to why our nation is so messed up politically. Liberals and Conservatives alike can’t accept anything other than their own ideology, regardless of if it’s right or not. I consider that pure ignorance. This goes far beyond the “I like strawberry over vanilla” debate, because that’s an individual preference that only affects you. When we bring in a philosophy or government that ends up affecting everyone, that full-fledged ignorance ends up leading to apathy, hatred, or completely illogical thinking.

    May God have mercy on our nation for what it’s doing and going through.

  31. Michael says:

    Johanna, I do read books by unsuccessful investors. Like Cramer. :)

    Seriously, there is advice out there that will wipe out 100% of investors, advice that will wipe out 80%, 60%, and so on. There’s no advice that makes money for everybody because nothing is right all of the time and not everyone is able to follow the advice.

    Katie, Cramer made his wealth from books, TV and TheStreet.com. As a professional investor he made much more money from wrap fees than performance fees. He didn’t get rich from “buy and homework.” Also, I don’t know why you and Trent think conservative advice equals good advice. I have read a lot of bad conservative investing advice.

  32. GayleRN says:

    When someone asks me how to acquire knowledge about investing I advise them to read everything (and I do mean everything) they can get hold of. The reasons I say this is twofold. First most people are unwilling to put in that kind of work and they just naturally go away. Second, you start to see and detect BS, illogic, and what are simply a variety of approaches. Meanwhile, until you get to the point of being willing and able to pick individual stocks (if that ever happens)index funds make perfect sense. That way you are at least invested and not spinning your wheels.

  33. theCase says:

    I agree with your opinion on people’s biases.

    A good example is looking at the reviews on Amazon with anything of substantial value like a TV, you’ll see reviews like “This is the best TV EVER!”. The reality its that 1) this person did not test every TV out there so they have no way of knowing, 2) if they don’t like it they probably will not post “I made a mistake” to the world.

    We all perceive ourselves as being a good judge of value and making correct decisions in our life, Isn’t rationalization wonderful?

  34. psychsarah says:

    Thanks for this post Trent! I learned tons about confirmation bias in my research training, as scientists are supposed to find counter arguments to their hypothesis and disprove them, not simply
    “prove” their own hypothesis with confirming evidence. It drives my husband batty that I’m always critical/cynical about claims of all kinds, and I try to find other explanations and evidence to disprove whatever was said. Now you’ve blessed this approach and I’m grateful :)

  35. Rob Bennett says:

    Wonderful post.

    Humans are not often persuaded by logic. We are more frequently persuaded by repetition. The people who make television commercials all know this, of course. But the people who give money advice seem to miss this point.

    Why do we believe in buy and hold? And that timing doesn’t work? And that stocks are always best for the long run? Because we have just lived through the most out-of-control bull market in history and those were the marketing slogans that were being repeated over and over and over again.

    Once that particular set of marketing slogans bankrupts us yet again (it always has in the past), we will become persuaded by a new set of marketing slogans.

    Rationality is rooted in logic. But most money advice is rooted in marketing.

    Rob

  36. Erik says:

    Great article; I think it would behoove the readers to share the points and examples shared by the ‘opposing’ reader as well! I’m interested to see those arguments, the facts, and people that support such claims. Total knowledge is crucial!

    Great community you’ve built-

  37. todo es bien says:

    Hi Michael, #16, you may wish to investigate a related issue, “Survivor Bias”. If you come to really grasp it, this will help you understand why those who have succeeded should be scrutinized just as much (or more) as those who have failed. Best regards.

  38. sknelson says:

    I totally appreciate this line of thought! I never considered this in regards to finances, as it applies to so many other areas of life as well. Obviously, taken too far, you end up so open-minded that your brain falls out. But pushing yourself to confront a challenge to your thought is so healthy. And I think most of us would do well to apply this. Thanks Trent!

  39. Michael says:

    Todo es bien: Successful investors and failed investors, as groups, have different characteristics. One of the differences between these two groups is what they read and how they think.

    Let me say that again: good investors think and act differently than bad ones whether any of them are still around or not.

    Todo, I have analyzed stocks professionally in the past, trade my own account today and have a good track record for someone without inside information. I wouldn’t trust my career or my money to copying the behavior of some Morningstar index as you suggest. Respectfully I suggest you research what kinds of money managers are correlated with good performance, and whether any of them might also cause that performance.

  40. Katy says:

    “It’s simple – my confirmation bias kicks in and I view my own performance as an outlier – a fluke.”

    This quote strikes me as somewhat rediculous. When you are investing, don’t you want to be an outlier? I know we’re not going for the huge bucks here (as they come with huge risks) but if you have the knowledge to choose consistent stock performers, then you ARE an outlier. Its a skill you have that most people haven’t cultivated. Being an outlier is not always a fluke, and its not always bad. Sometimes its the goal.

  41. todo es bien says:

    Thanks for your thoughtful reply Michael. A careful read of my previous comment will reveal that I make no mention of Morningstar or indexes at all, so that is puzzling. Be that as it may, I in essence agree with your suggestion. I believe that there is some correlation between skill,discipline, and results when it comes to investing outcomes. What I was trying to say was that in many cases there is more than meets the eye, and understanding various kinds of biases can be illuminating and possibly interesting. At any rate, sounds like you are doing well and are happy and successful, so probably my notion would be of no use to you. Best regards, t.e.b.

  42. Carrie says:

    Trent:

    You would enjoy reading a book called “How We Decide”, by Jonah Lehrer. It’s a fascinating look at how and why (from a brain-science perspective) we make the decisions we do; one of the chapters discusses this exact thing.

    Your post about being a control freak, and how it didn’t help you save money, was incredibly helpful to me – I have the same issue. Your example of the grocery store, in particular, was enlightening.

    Thanks for all you do,

    Carrie.

  43. Georgia says:

    I had a bias against foreign cars. We always bought American. I had a 79 Buick Electra Ltd. that zoned out at 363k miles, 250k of which I had put on in about 8-9 years. Later I had a 91 Chev Lumina that got 316k miles before it quit. I now have a 2000 Ford Taurus SE station wagon with just less than 168k on it. It is running great.

    My husband bought a used 91 Toyota pickup. He admitted that it had very little problems for the lack of care he had given it. After about 5 years, he drove it mostly around home because, if he drove over 50-100 miles straight, he would have to put a quart of oil in it. We had it about 9 years. And it was used hard, with going through ditches, mud, and farm land, and with being overloaded a lot with stuff he used keeping the fairgrounds up.

    Good arguments on both sides. Just do your homework and take good care of what you get.

  44. Anthony says:

    Great Post. I see this all the time in the fitness industry. Most people believe ONE modality is the absolute best and only follow the experts of that modality. Mike Boyle, who is an extremely successful and intelligent strength coach said “Don’t believe everything you read, but don’t just read what you believe” The ability to analyze information and make intelligent decisions based on that is our greatest tool.

  45. Jerry says:

    I have read a lot of comments based upon feelings or assertions, but few very facts. This topic fairly screams out for numerical confirmation. Trent laid out the facts about index funds. To me, the key points are:
    1. If your actively managed fund does not over-perform a low cost index fund over many years, then you are throwing away your money. The lowest cost index funds outperform 80% of all actively managed funds over 10 years, mainly due to the lower cost. The out-perfom percentage rises to 95% when comparing a set of 5 funds. Most people need to be diversified, so most should have those 5 funds, making 95% a more realistic number. See CNN/Money, Morningstar and http://www.fundalarm.com for a comparison of funds. Vanguard and T.Rowe Price consistently make the list of top 70 funds in Money’s ratings.

    2. If you do not manage your money consistently _better_ than a professional over the long term, then you have no rational reason to do it yourself. If you are not doing the math to compare your results those of a professional, then you are wasting your own money and time. You have to include ALL expenses, trading costs, capital gains taxes, and fees. Anything else is cheating (yourself).

    3. In my humble opinion, if you’re only making less than or even the same amount of money for yourself as an inexpensive index fund would give you, then (a) great! you have learned something useful, and (b) now you can turn that money over to Vanguard or T.RowePrice, and go out to do something else with your lifetime. Unless you are a fool who enjoys overpaying some moron to steal your money, you would do better 95% of the time with an index fund (see 1). Unless you are or want to become a financial professional, then managing your own money merely to save the 0.2% index fund fee (see 2) means that you are wasting time in your life better spent living. I am not advocating blindly turning your life savings over to some random guy in a suit. Do your homework _first_, invest wisely, then go live your life.

    4. This has nothing to do with your brains or your ego. This certainly does not have anything to do with “enjoying” stock trading. If you run the numbers and _honestly_ compare results, then go with what is best for you (and your family, if any). Better yet, have someone else (someone objective like an accountant) run your numbers. In 99.9999% of cases, if you are not a financial professional, then you are wasting your money. If you haven’t run the numbers brutally honestly but still think you are the 0.0001% who beats the experts, then you are probably fooling yourself.

  46. Michael says:

    Todo, I do appreciate the reminder. :) Pride and greed threaten any investor regardless of his skill and knowledge. And as they say, you can always lose 100% of your investment.

    Morningstar Index was a reference to the mutual fund indexes published by that company. Most mutual fund companies are able to advertise their good standing in Morningstar’s reports due to confirmation bias, since the losers have closed or folded into successful funds.

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