Don't become a one-eyed investor

May 31, 2017

Behavioural economists warn investors about a trap known as "confirmation bias". This involves deciding on a course of action and then looking around for evidence to support that action.

The proliferation of online investment newsletters and blogs means that investors can almost immediately find someone, perhaps a so-called expert, who agrees with them.

In short, the trouble with "confirmation bias" is that it blocks out contrary opinions and research.

As investors try to come to terms with the outlook for lower returns in this low-interest environment, they may be particularly vulnerable to falling into the trap of "confirmation bias" as they seek to bolster their returns.

However, investors should treat the overload of opinions available as another form of market "noise" that must be carefully filtered so as not to distract them from their long-term goals.

Vanguard's chief executive, Bill McNabb, recently warned that in times of increased investment uncertainty, it's easier for investors to make bad decisions.

And this, writes McNabb, includes a greater likelihood of falling prey to "focusing on just the information that confirms our decisions". In other words, "confirmation bias".

A research paper, Understanding how the mind can help or hinder investment success* – published by Vanguard published several years ago, suggests that investors use a decision-making checklist. Such a checklist would include reasons why an investor should not take their proposed course of action or what could go wrong.

As renowned behavioural economist Dr Richard Thaler of the University of Chicago writes in his latest book, Misbehaving: The making of behavioural economics, people have a "natural tendency to search for confirming rather than disconfirming evidence".

So, don't be surprised if you suffer from at least a little "confirmation bias".

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Understanding how the mind can help or hinder investment success by Stephen Utkus, director of the Vanguard Centre for Investor Research, and a former Vanguard senior investment consultant, Alistair Byrne. 

Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.

Reproduced with permission of Vanguard Investments Australia Ltd

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