How to Beat The Most Dangerous of All Biases

By TradeSmith Research Team

We know that certain bad habits are hazardous to your health. And many know that cognitive biases — irrational tendencies built into the brain that lead to poor judgment — can be hazardous to your wealth.

Over the past six decades or so, dozens of cognitive biases have been identified. One of the oldest and most dangerous of these is “confirmation bias.”

There is no way to calculate the total amount, but it’s safe to say veritable oceans of investor wealth have been lost to confirmation bias. And for investors in the present day, confirmation bias is just as dangerous as ever.

That’s the bad news. The good news is, there’s a simple way to beat confirmation bias — or at least to safeguard against it.

What is confirmation bias exactly? Roughly speaking, confirmation bias is:

  • The tendency to support an existing point of view
  • A habit of seeking evidence that “confirms” a favored point of view
  • An additional habit of rejecting evidence that challenges that view
  • A habit of modifying judgment and memory without realizing it

Put more simply, the human brain wants to reinforce the views it already has. If emotion is involved, the tendency gets even stronger.

And the whole process works at the subconscious level. It is possible to be wholly in the grip of confirmation bias without even realizing it — even as it “feels” like you are being 100% rational.

Intelligence is no defense against confirmation bias. In fact, the smarter you are, the more exposed you are to confirmation bias as a rule, because smart people are better at rationalizing after-the-fact justification for their beliefs.

As the science writer and famed skeptic Michael Shermer puts it: “Smart people believe weird things because they are skilled at defending beliefs they arrived at for non-smart reasons.”

This explains why confirmation bias is so dangerous for investors. When it comes to investing, nobody is right all the time. There are times when a wise investor has to say, “I was wrong,” or otherwise change their mind on a thesis or let it go.

But if the investor is emotionally attached to their initial investment, or point of view, or both, confirmation bias can lock in that sense of attachment. This leads to heroic acts of rationalization, as the brain seeks out ways to defend an existing point of view, while denying or selectively ignoring evidence that goes against that point of view.

For investors specifically, unchecked confirmation bias can cause losses ranging in size from modest to disastrous. When a famous investor gets on a bad path and loses billions on an investment — which happens more often than you might think — some version of confirmation bias is usually involved.

Confirmation bias makes it hard to let go, precisely when a non-biased analysis would strongly favor letting go.

It can also lead to missed opportunity, like when an investor misses a multi-year bull trend in an industry or sector because they refused to change an initially negative point of view.

Confirmation bias was discovered almost 60 years ago, by a cognitive psychologist named Peter Cathcart Wason at University College London.

Dr. Wason pioneered the “Psychology of Reasoning” an inquiry into the mistakes people make on a consistent basis. He coined the term “confirmation bias” to describe the tendencies he documented after running a series of experiments.

One of Dr. Wason’s most famous experiments not only underscores the presence of confirmation bias, it shows how you can beat it, or at least safeguard against it, by developing a simple habit that is counter-intuitive for most people.

The experiment, carried out in 1960, was known as the “2-4-6” task. It worked like this:

  • The subjects were shown a set of three numbers: 2-4-6.
  • The subjects were told a certain rule determines the sequence.
  • The subjects were asked to try and figure out what the rule was.

For the subjects of the experiment, the 2-4-6 task looked like a logic test. They were encouraged to propose different sets of numbers in order to test a hypothesis as to what the “rule” was that generated the 2-4-6 result.

The majority of subjects in the test followed a pattern that looked like this:

  • They intuited the pattern was a rise of even numbers.
  • They would offer guesses like “8-10-12” and “14-16-18”.
  • The experimenter would say “correct” multiple times.
  • The subject would confidently guess the rule.

The subjects of the experiment tended to be absolutely confident in their final guess — that the rule was a pattern of rising by two or starting with an even number and adding two each time.

But that was wrong: The actual rule was, “three rising numbers in sequence.” The initial 2-4-6 was a deceptive pattern. It could have been any three numbers. A guess of 3-47-104 would have worked just as well.

The 2-4-6 task was remarkable in what it showed via the common pattern of behavior in the test subjects.

  • Most of the subjects started with a hunch that the 2-4-6 pattern was “rising by two each time.”
  • Most of the subjects then offered guesses in line with their “rising by two” theory.
  • And most of the subjects then offered their opinion with a high degree of confidence — and were likely shocked and surprised when told they were wrong!

The funny thing here is, the subjects could have challenged their own hunch at any point.

There was no penalty for offering a series of numbers to which the experimenter said “no, that’s not it.” All a subject would have needed to test their hunches would be trying a series of numbers that didn’t conform to the rising-by-two rule, just to see what happened.

But again, most people didn’t do that. They got an early hunch, and it solidified in their mind, and their hunch grew stronger with every additional number sequence they tried — because they never attempted to disconfirm their original view.

And that was another funny thing: If you thought the rule was “rising by two,” and you only offered up test cases that supported your idea, you could offer fifty test cases, or a hundred, or five hundred, and the experimenter would say “yes that fits the rule” every time — and your final guess at what the rule is would still be wrong.

This brings us to the five-word recipe for beating confirmation bias: Seek to disconfirm your hypothesis.

Confirmation bias is wired into all human brains. Countless experiments in the decades since Peter Wason’s 2-4-6 task have confirmed that finding over and over.

The way to fight back against it is to do something counter-intuitive: Make a regular habit of playing devil’s advocate with yourself. Habitually challenge your favored point of view.

Ask yourself: “What could make me wrong?” Or “How can I see this differently?”

It is not at all a normal habit to question one’s own assumptions — to take the time and effort to challenge your own point of view. The brain is not built that way.

It is a strange idea to most people to regularly doubt your own theories, or to try to step back and imagine what a situation might look like through the eyes of a different person — someone with a completely different point of view.

But the strangeness of this habit, the counter-intuitive nature of it, helps explain why it can be so useful to investors. To counter the cognitive biases that are hardwired into the brain, we have to engage in activities that sometimes feel uncomfortable.

When natural ways of thinking lead to irrational results, we can use higher order cognitive tools to adjust the image and bring rationality back into the picture.

The habit of confirmation bias is so pervasive and dangerous — especially when it comes to investing — that making a counter-habit of saying “what could make me wrong?” or “how can I see this differently?” can be hugely valuable over time.

TradeSmith Research Team