10. Confirmation bias

At the heart of the confirmation bias lies our inherent human psychological need to not only want to be right, but also to take comfort in being “right”.

This translates into people only wanting to expose themselves to opinions and thoughts which mirror their own.

Good general examples of this can be found in politics, where individuals who hold certain political views only congregate with others who hold the same views.

Naturally, this leads to a society bifurcated along political lines, where folks from each political tribe get their news from the same sources and share their (very similar) opinions in the same social media groups.

The end result is that people get stuck in a giant echo chamber where dissenting views simply do not exist, and accepted opinions are constantly reinforced through never ending repetition.

This applies to financial markets as well, where traders tend to be split into two camps: bulls and bears.

Confirmation bias sets in when bulls only ever read narratives that agree with their point of view, that is market analysis and commentary which only talk about how markets can keep going up.

Conversely, bears who are stuck in their confirmation bias only follow pessimistic narratives which predict a coming market crash.

Good examples of such polarization include the debate around Tesla’s share price, the nature of 2021’s inflationary spike (transitory or not?), and whether Cryptocurrencies are worth some astronomical amount or $0.

The danger for traders, and their trading accounts, lies in only following one side of the narrative.

Bulls who only read about how markets can only ever go up will believe that markets can only ever go up, and be completely unprepared for market downturns. Likewise, bears who only read and talk about how markets are going to crash expose themselves to catastrophic losses during bull markets.

Consequently, the confirmation bias affects traders’ opinions and thoughts before they even put on a trade. This means that trade management skills and techniques that are so effective in mitigating other cognitive biases like the disposition effect aren’t as useful against the confirmation bias.

After all, a trader who consistently implements stop losses but only ever shorts the market will still lose a lot of money when the market embarks on a multi year rally.

In order to guard against confirmation bias, we have to first be aware of it, and then make the conscious effort to balance out the information we choose to digest. In this way we can at least have a more holistic picture of possible future scenarios before entering into a position.

Another highly effective, although less popular way of mitigating our natural confirmation bias is to trade in a manner that is not dependent on having a view on what markets will do in the future.

While this may sound strange (possibly even heretical) to some, it simply means not having an opinion on whether a market will go up or down, instead trading only on what market prices are indicating.

Trend following is a good example of this, where traders focus only on price to indicate whether or not a market is trending, and position themselves accordingly.

However you choose to deal with your own confirmation bias, just remember that echo chambers exist in all aspects of our lives, not just trading!