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Democrats took control in Washington and began laying out their agenda for the next four years. Many media outlets across the country may shift their economic outlook as a result. The press organizations that were negative on the markets, foreign policy, defense, and healthcare, over the last four years may now turn positive due to a new administration. Conversely, the journalists who had been positive may suddenly turn pessimistic. This display over the next few weeks, with both sides selectively using stories and examples that support their predetermined agendas, will be a perfect illustration of confirmation bias.
Confirmation bias, or the tendency to interpret new evidence as validation of one’s existing beliefs, is also one of the biggest behavioral challenges for investors. It could cause us to selectively gather information that supports our personal viewpoint, while filtering out potentially useful facts and opinions that don’t coincide with our preconceived notions. This bias may lead to overconfidence in our beliefs, sometimes in the face of obviously contrary evidence.
Exhibiting confirmation bias in the political realm may cost you friends or followers on social media who do not appreciate your closed-mindedness and perceived lack of objectivity. When it comes to investing, such a bias may cost you money by preventing you from empirically evaluating data and causing imprudent investment decisions.
Looking back at our past two Presidential reigns, one can see numerous practical examples of confirmation bias affecting investors. Presidents Obama and Trump stirred strong feelings on both sides of the political aisle. Some folks were inspired by them and, at the same time, others thought they were going to destroy the country. These strong feelings sometimes carried over into investment decisions. At every election, I had friends and colleagues confide in me that if their desired candidate did not win then they planned to promptly move their portfolio entirely into cash as they were certain that the market would crash. Some of them would then back up their thesis by sharing articles that supported their own point of view.
The drastic decision to overhaul one’s portfolio based on who is in office turned out to be the wrong approach in both scenarios. The Dow Jones Industrial Average had very similar annualized returns of 12.1% and 11.8% for Obama and Trump administrations, respectively. Sitting on the sidelines for either president was a poor choice, regardless of your political affiliations. Staying invested over the past 12 years, through both presidents, would have made you a lot of money and brought you closer to achieving your financial and retirement objectives.
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Confirmation bias with investing also prevails outside the realm of politics. An individual may decide to invest in a company, whether for legitimate reasons or because of their catchy message, sleek products, or being enamored with the CEO. As new information emerges, attention is given solely to commentary that supports the initial viewpoint to buy, ignoring any obvious concerns of impending financial disaster like lower sales, financial fraud, or a possible bankruptcy. Holding on to such an investment may seem silly to the objective outsider, but people tend to reassure themselves of their original thesis even if it could lead them to financial ruin.
Every person suffers from some form of confirmation bias. The key is not letting it derail you from being able to achieve your financial goals. The key for investors is to establish a process to overcome the biased behaviors, which could include three key components:
1) Find an objective sounding board: Find an unbiased, knowledgeable person, ideally outside your social circle to minimize groupthink, to bounce ideas off and challenge your investment thesis. This can be a financial advisor or any third party who isn’t afraid to play devil’s advocate. Simply discussing your investments before executing them helps minimize emotional decisions.
2) Clearly define your goals: A great way to start is by crafting an Investment Policy Statement (IPS) that outlines your objectives. It should also clearly define what you will be investing in, why you are investing in it, and how it will help you achieve your goals. Referring back to your IPS when in doubt can help you stay on track during tumultuous times.
3) Implement a rules-based approach: A systematic approach to investing helps minimize emotions within your investment strategy. Investors can set predetermined levels for the weightings of each investment within the portfolio. The important decisions of when to buy, sell, or add money can all be automated through processes like dollar-cost averaging and rebalancing. Investors can set up the portfolio to automatically rebalance at set times throughout the year or when any particular investment hits a certain threshold. This calculated approach allows the portfolio to be managed prudently without tinkering with it based on your personal beliefs. Similar processes can be set up if you are in the decumulation stage of retirement and need to withdraw money on a regular basis.
The media’s reaction to the transition of power from one political party to another is a good reminder of behavior to avoid when investing. Lively discussions about politics make great hobbies, but those heated emotions should not carry over into your portfolio. Establishing a process-oriented approach can prevent you from derailing yourself from achieving your financial goals.
Disclaimer: This article authored by Jonathan Shenkman a financial advisor at Oppenheimer & Co. Inc. The information set forth herein has been derived from sources believed to be reliable and does not purport to be a complete analysis of market segments discussed. Opinions expressed herein are subject to change without notice. Oppenheimer & Co. Inc. does not provide legal or tax advice. Opinions expressed are not intended to be a forecast of future events, a guarantee of future results, and investment advice. Dollar cost averaging does not guarantee a profit and does not protect against loss in declining markets. Investors should consider their ability to continue making purchases through periods of fluctuating prices.
Dollar cost averaging does not guarantee a profit and does not protect against loss in declining markets. Investors should consider their ability to continue making purchases through periods of fluctuating prices.
The Standard & Poor’s (S&P) 500 Index is an unmanaged index that tracks the performance of 500 widely held, large-capitalization U.S. stocks. Individuals cannot invest directly in an index. Adtrax #: 3417619.1