Introduction to Confirmation Bias Example
Confirmation bias is a phenomenon that characterizes with the tendency or behavior to favor, interpret or recall information in a way that supports your pre-existing beliefs and notions without any reasoning or logical evidence. In fact, it is not only confirming the notions, but people also show this tendency while research or gathering information in a selective way. Many psychological experiments conducted across the planet in the 1960s confirmed this behavior and since then it has become the darling of marketers in strategizing their campaigns to cross-sell or increase wallet share from the customers classified as cash cows. The explanation for this illogical behavior has been proposed as selective listening, selective research, biasedness, emotionally charged ideas or deep-rooted or age-old beliefs.
Examples of Confirmation Bias
Few examples of confirmation bias are as follows:
#1 – Stock Markets and Participants Behavior
Stock markets have been the biggest example of confirmation bias over a long period of time. The place often thought of a platform where intellectuals make money while speculators consistently lose has time and again proved that often reactions are knee jerk and in the heat of the moment. A simple rule of finance states that when the economy is booming, the equity should give you better returns while when the economy is going through a rough phase, safe assets like sovereign bonds and gold should be preferred. But what happens when a large firm in a booming market post unexpected result. The unexpected result might be different from the expectations in terms of top-line numbers but still, an analysis is required to understand what lies beneath.
In order to understand how the firm has performed in the last quarter, the layers of these implicit details need to be decoded one by one. But what market participants actually do? They only look at the initial set of numbers and if these numbers are unexpected, they start selling the stock of the firm. The simplest reason being they have been conditioned to react in such a way over the years. Just because everyone is doing it, one should do the same. This leads to a knee jerk reaction, often an overreaction by the market and its participants. That is why we sometimes face situations where stocks of even blue-chip firms are down by 5 -10 % even when they have posted decent results. An investor with basic knowledge of finance but who is able to calm his anxiety and avoid blind sheep behavior can weather these storms and in fact, used these situations to generate better market returns. This is a classic case of confirmed biasedness in behavioral finance and its effect on investors.
#2 – Option Traders and their Biasedness Towards Puts
Confirmation bias can be best understood with the example of how the option traders take their positions. Both option buyers and writers have a general view of the underlying instrument (say Index) and based on this view they take positions. The option premiums are calculated based on the probability hitting the strike price before a pre-decided contract expiry date. Mathematically the probability of underlying instrument moving by a particular percentage point in either direction is the same, assuming there is no negative or positive news already reflected in the prices and the volatility is not at unprecedented high levels because of any major event shaping up. However, even though the probability is the same, there can be a difference in the premium amounts charged for calls and puts.
Let’s consider an example where the index is trading at 10,000. For our analysis, we consider two strike prices – one 200 points above the current spot price and one 200 points below the current spot price. The following table summarizes our scenario.
Mathematically, the probability of a 200-point movement either way in the index is the same. However, still, the premium of the put is greater than the premium charged for the call price. The simple reason is that the market participants are biased towards a sell rather than buying and hence they are ready to pay a higher premium for the same. This scenario is often referred to as volatility smile in Market risk.
#3 – New Investments (Catching a Falling Knife)
Confirmation bias can be seen in the case of retail investors when they make new investments. Let’s say one wants to invest in a company that is on the brink of Bankruptcy. Now the Management of the firm will try to recover the maximum value from its assets and payout its debts as soon as possible. In the newspapers, you will find two types of news related to the firm. One related to how management is trying to reduce its debts and how successful it has been and the other related to how these tasks are fruitless and are pushing the firm further into bankruptcy. Again, there will be opinions on both sides. Depending on the opinion one has framed with the initial encounter of the news, one would interpret those opinions accordingly leading to confirmation bias. The thought of making quick money further acts as a catalyst and force people to take positions on this new investment even though the common ratio is to stay away from these investments as it is often termed as – “Never catch a falling knife”. But that is rarely the case as not only new investors but even the seasoned investors fall prey to them and end up losing money.
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Conclusion
Confirmation bias tendencies play a major role in shaping up to our opinions from the interactions we have with the outside world and eventually our decision. It’s not that opinions or logical reasoning questioning our opinion are not encountered. In fact, they are very much present in front of our eyes, but we choose to either ignore them or interpret them in a way that suits our reasoning and confirmed biases. The most effective way to deal with this concept of behavioral finance is to be the devil’s advocate and weigh each opinion with an objective frame of mind.
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