Behavioral finance is one of the fast-growing fields in our industry. TPG’s John Woolley and Stuart Robertson examine one of the more important topics as it relates to people’s finances: confirmation bias.
As you’ll hear in the video and read about in the accompanying blog, the human brain can sometimes work against us — such as emotional decision-making when dealing with your finances.
Since 2012, the average investor’s performance trailed the classic 60/40 portfolio by nearly 3 percentage points per year and the S&P 500 by almost 8% (Fig. 1)! Why? EMOTION.
Figure 1. J.P. Morgan.
As humans, our brains work against us in many ways. In investing, emotional decisions and cognitive errors have meaningful consequences. Traditional economic and financial theories make an important but unspoken assumption that individuals act rationally; however, in the real world, we find individuals rarely act completely rationally. We tend to fall prey to our confirmation bias and many other behavioral biases. This is where the field of behavioral finance comes in, examining the intersection of how individuals and markets actually behave. Behavioral finance is one of the fast-growing fields in our industry, so today we will examine one of the more important topics as it relates to people’s finances: confirmation bias (Fig. 2).
Confirmation bias is defined as “the tendency to look for and notice what confirms prior beliefs and to ignore or undervalue whatever contradicts them.” Confirmation bias is (at its core) an emotional reaction, and it casues issues when it influences investment decisions. Failing to recognize this error creates blind spots and causes us to cherry-pick information that conforms to our deeply held beliefs. Let’s look at how confirmation bias works in practice, why it matters, and potential ways to check this bias.
Figure 2. Nielsen Group.
We currently see confirmation bias at play in the repetitive fear that the US dollar is about to lose its status as the world’s reserve currency. Considering the height of geopolitical tensions in 2023, some have suggested that China, Russia, and Saudi Arabia will ditch the US dollar in favor of their own currency to skirt sanctions and other trade related issues. The demise of the dollar as the reserve currency is not a new fear, and paying attention to only the headlines may confirm and heighten our fears. Over the years, headlines about a replacement for the dollar have varied from the rise of the euro to the Chinese yuan being included in the World Bank’s Special Drawing Rights. Finding evidence to represent the full picture takes time, research, and data. Given there are no stories written (and, therefore, no headlines to read) that proclaim “The US Dollar Is Still the World’s Reserve Currency!” it is all too easy to find stories to confirm a view of the US dollar’s demise. Never mind that the dollar is still the most abundant currency in the world, making up 52% of foreign currency reserves and 44% of global trade (see Fig. 3). If we want to find support for our fears, we will.
Figure 3. International Monetary Fund and Bank of International Settlements, as of 12/31/2022.
We can also see this confirmation bias in topics like the US debt level. Congress recently skirted default by raising the debt ceiling for the 78th time since 1960. However, the narrative surrounding the debt limit has revolved around its “unsustainable nature.” The total figure for US debt is certainly appalling (topping $32 trillion), but if we only focus on the top line number, it simply reinforces the belief that we have too much debt. What’s often overlooked is the serviceability of that debt. Corporate profits are at an all-time high in the US (Fig. 4), and higher profits translate into higher tax receipts. As a percentage of GDP, the interest payments on our debt have remained stable for the past 20 years. In fact, the percentage of interest payments to GDP was much higher in the late ‘70s through the mid ‘90s. In some ways, it can be compared to an individual making minimum payments on a credit card: at some point, the balance will need to be paid but, we can get by making the payments today.
Figure 4. US Bureau of Economic Analysis, as of 06/15/2023.
How do we combat confirmation bias? One good step is to seek out information that challenges our existing beliefs. By doing this, we are forced to consider topics from another perspective. This is exactly what we do as an Investment Committee at The Partners Group. Each member brings a different background to the table, challenging assertions and poking holes in everything we do. We actively seek out the other side of every argument. Our econometric model also has a role in combatting our emotions, forcing us to consider a broad data set rather than our personal favorites.
Behavioral finance is a vast and powerful field of study; we have barely scratched the surface here. If you’d like to know more, please join us at one of our next Behavioral Finance events, hosted throughout the year, during which we cover many biases that can impact investors.
As always, we love hearing from our clients.
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