Learn the stock market › Market psychology › Lesson 3 of 6
What is confirmation bias in investing?
Two rules that both have proof
Say you believe that a stock that jumped one day keeps going up. A friend believes the opposite, that the time to buy is after a fall. Both can find thousands of examples:
| After | Higher a month later | Lower | Share higher |
|---|---|---|---|
| A day up 3% or more | 4,741 | 3,662 | 56.4% |
| A day down 3% or more | 4,354 | 3,259 | 57.2% |
| Any day | 68,208 | 47,600 | 58.9% |
Each rule has thousands of hits, and thousands of misses too. What tells you something is the share, and it has to be compared with any day. On any day the price was higher a month later in 59% of cases. After a day up 3% or more it was 56%, after a day down 57%. Both rules had plenty of examples to point at, and neither differed much from an ordinary day.
Why the trap works
Someone who believes in a rule notices the hits. They confirm, and they stick. The misses are explained away as exceptions. With thousands of cases to choose from, you can fill a whole forum with examples pointing either way.
The protection is to count every case, including the ones that go against you, and to compare with an ordinary day. That is how five well-known signals were tested in the study of technical analysis, and large one-day falls in the study of what happens after a crash day.
The same with news
An owner happily reads the good news about a company and skips the rest. Someone who has sold does the opposite. Both get their picture confirmed. One way to push back is to write down why you own a stock and what would change your mind, before the news arrives.
Test yourself
Someone shows you 50 examples of a rule that worked. What else do you need to know?