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Behavioral Finance Series: Confirmation Bias

Behavioral Finance Series: Confirmation Bias

March 09, 2023

Behavioral finance is the study of the effects of psychology on investors and financial markets. It focuses on explaining why sometimes people make emotional rather than logical decisions, which often act against their own best interest. At DDK, we believe the more we understand the biases that cause financial decision-making errors, the more success we will have together. This is the third in a series focused on behavioral biases.

 Confirmation Bias

 On February 19th, 2020, the S&P 500 closed up 4.8% year-to-date, continuing the strong 2019 momentum; a year that finished up 29%.  On that same day, the Diamond Princess cruise ship floated silently off the coast of Japan, all passengers quarantined aboard due to a large number of them testing positive for something called Covid-19.  And the rest is history.  For the remainder of 2020, we all experienced a world we never thought possible.  We suffered unimaginable human tragedy but also strength and resiliency.  The stock market experienced the ebbs and flows with a wild ride that brought us to an intra-year low of -34% but closed the year at +16% as people became more hopeful of the days ahead. 

 John, our client, was less hopeful as we entered 2021.  He believed the market recovery was not sustainable and shared many articles stating that the market was sure to revisit the lows set in March of 2020. John proposed we should move defensively by selling 50% of his equity exposure in favor of cash.  Through his research, John was exhibiting a classic case of confirmation bias, which refers to a selective perception that emphasizes ideas that confirm one’s beliefs, while devaluing whatever contradicts that belief.  In this internet era, there is a generous amount of information, and opinion, that can be powerful but dangerous at the same time.

 Recognizing John’s bias, we first revisited his financial plan and made sure that, if his belief proved correct, he and his family would still be able to meet all his goals.  They could.  Next, we examined the history of the market during other uncertain time periods and saw performance often did not match the emotion at the time.  Last, we reviewed his research and other research that discussed the contra view.  Ultimately, we concluded to stick to our long-term plan, trimming his stock positions back to target based on the recent growth, as John saw the risk of a 50% correction as real.  In 2021, the market rose another 27% and John was positioned to capture what the market gave him.  We then retrimmed his stock positions heading into the 2022 market.    

 Should you wish to discuss this or any other topic, please do not hesitate to reach out to a member of our team. 

Hypothetical client situation. This is not meant to reflect a typical client experience, rather the kinds of relationships we endeavor to engage.