Have you ever had an idea and then found yourself gravitating toward evidence that supports it? People often favor information that fits with their preconceptions—and ignore information that doesn’t.
Psychologists call this process “confirmation bias.” The tendency to unconsciously filter information according to one’s worldview affects many types of behavior, and when it creeps into the world of investing, the results can be costly.
Making disciplined investment decisions can be challenging under the best conditions. Here are a few ways to limit the effect of judgment-impairing biases on your investing.
- Acknowledge the issue. Recognize that confirmation bias can cloud your investment decisions and consider probing your assumptions for potential irrationalities. Being aware of confirmation bias could be a first step toward managing it.
- Understand what you are buying. Before you buy a stock, seek out information that might contradict your investment idea. Is there anything you’ve been overlooking? You should also think about any potential changes in the business or markets that would make your investment less attractive. For example, would the emergence of an innovative competing product upend the business model of the company you want to invest in? Writing down a list of pros and cons can help you make a more thoughtful, balanced decision.
- Know when to sell. Create a list of sell triggers when you buy a stock. Monitor those triggers, and if any are tripped, sell. Deteriorating company fundamentals are one possible sell signal. You should also think about a stock’s role in your overall portfolio. Does maintaining a certain position push your portfolio away from your target allocation? If so, you might consider selling.
- Limit your downside. It may be worthwhile to set a limit on how much capital you devote to a single investment. For example, you could impose a cap of 5% of your portfolio for long-shot ventures and then stick to it.