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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