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Financial Advice

The Value of Playing Devil's Advocate in Investing

Confirmation bias can lead investors to make bad decisions. Here's how to avoid it.

This is the 12th article in the Behavioral Finance and Macroeconomics series exploring the effect behavior has on markets and the economy as a whole and how advisors who understand this relationship can work more effectively with their clients.

Confirmation bias is a belief perseverance bias. It's a type of selective perception that emphasizes ideas that confirm our beliefs and de-emphasizes information that contradicts our beliefs. As humans, we believe what we want to believe, and we seek information that supports our beliefs rather than seek information to the contrary.

Cable TV provides an example. For some, MSNBC is the preferred source for political news. For others, Fox News is preferred. Why? Because we naturally seek out information that confirms what we want to believe. This is confirmation bias in action.

In investing, confirmation bias runs rampant. From clients to advisors to even money managers, we humans constantly seek information that supports or confirms our beliefs while discounting information that contradicts our beliefs. As a result, less than optimal investment decisions can be made without realizing it, and over time these decisions can erode overall portfolio performance and possibly jeopardize reaching financial goals.

Let's consider a specific investment example of confirmation bias. It is the end of 2013, and you are planning to recommend that clients shorten the durations of their fixed-income portfolios because interest rates in the U.S. hit a fresh low midyear and are slowly rising toward a 3% yield on the 10-year bond. You look at a chart that shows that "normal" 10-year bond yields are more toward the 5% range. Right before you make the recommendation, one of your colleagues shows you what happened in Japan over the past 20 years, during which interest rates stayed very low for a very long time. When presented with this data, you say to yourself, "This is crazy. This could never happen in the U.S." You move ahead with your recommendation, ignoring the Japan example.

What happened in 2014? Interest rates didn't rise and instead went back to the lows of 2013, with the yield on the 10-year bond dropping below 2%. You weren't the only one who thought yields would rise: This way of thinking occurred on a grand scale and many investors limited their bond returns. This is one of the many examples of confirmation bias that occur every day in investing. Many investors fell prey to this way of thinking at a macro level.

My advice for overcoming confirmation bias, as with many biases, is to learn to recognize it in action. I can't tell you how many times my colleagues and I say to each other, "Isn't that confirmation bias in action!" when trying to convince one another about an investment concept. Instead of immediately going with your instincts, try intentionally putting more weight on contradictory information than you typically do. Play devil's advocate with yourself, and make a case for how the contradictory information could be right. You may find that you change your mind based on the contradictory information. If, however, after this process, you can objectively say that your original view is still valid, then you should proceed with your course of action.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.

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