For investors, there's nothing quite like the rush from seeing a stock you bought race up 50%, or hearing a pundit on CNBC support your opinion, or witnessing a hated stock take a precipitous fall.
Unfortunately, that rush oftentimes clouds our judgment, and that can be a dangerous tendency -- both as an investors, and as a human beings. Lately, I've dedicated some time to investigating eight major biases we face as investors, and what we can do to mitigate their effects.
Today, we'll be investigating confirmation bias. Below, I'll demonstrate what it is, give you a real-life example of the bias in action, offer some ways to counteract this, and at the end, offer up access to a report that promises to help you overcome confirmation bias with the market's most talked-about stock.
A quick primer
All the way back in 2004, our own Bill Mann wrote a piece entitled "Beware the Confirmation Bias." In it, he gave the example of a poker player with a full house who keeps raising his opponent -- all the time thinking, "Sucker, I'm going to make you pay!"
In the end, however, the player loses out; his opponent had a higher full house. All the while, our loser had only been paying attention to cues that confirmed his suspicion that he was going to win -- never paying attention to the very real possibility that the opposite was true.
As Bill put it, "Confirmation bias is the human tendency to focus on news that confirms our biases, and ignore or reject any information that puts it into question."
Real-life example
This tendency runs rampant in the investing world. There may be no clearer example than the recent 45% increase in the stock price of Research In Motion (RIMM +1.16%) -- the maker of BlackBerry smartphones -- in 2013 alone.
Just over a week ago, I penned an article warning investors not to read too much into RIMM's recent rise. Since then, the stock is up 27%. To many investors -- including the commenters on the article -- this would prove that I was wrong, and that RIMM investors were right.
In reality, nothing could be further from the truth: Neither conclusion has been proven either way. Since Jan. 1, RIMM has officially released just two pieces of information to the SEC. The first was the introduction of the BlackBerry Curve 9315 Smartphone on T-Mobile's network, and the second was an announcement that RIMM received approval from Visa to use near-field communications for mobile payment solutions.
One of the biggest movers of the stock -- that you don't see in the SEC filings -- is likely the anticipation over the company's BlackBerry 10 operating system. That, combined with several analyst upgrades, has been moving the stock up rapidly.
Even news that Apple was cutting back expectations on iPhone 5 sales is being credited with pushing RIMM shares higher. Our own Evan Niu has shown that such concerns over iPhone sales need to be taken in context. But even more important, in no way does such news mean that BlackBerry sales will necessarily increase.
Don't get me wrong, there's certainly a lot of potential here. The Curve could be the first of many new and successful products coming out this year, and the deal with Visa could draw in more BlackBerry users. More important, the new operating system may breathe new life into the company.
Or it may not.
That's the thing with investing. You don't actually know if you were right or wrong until the company starts reporting its results. As Bill wrote back in 2004, "stock prices that are not confirmed by rising fundamental improvements will not stand."
What this means for you
If you bought into RIMM months back because you believed in the future of the company, congratulations -- you're sitting on a pretty nice gain right now. But before you buy more because of the stock's price action and a bevy of analysts who agree with you, remember that there's been absolutely no concrete evidence released to prove your thesis right.
In the end, one of the best ways to avoid the confirmation bias is to write down the top three reasons you wouldn't invest in a company, and reason out why you think the bears are wrong. It won't make you invincible from confirmation bias, but it should safeguard you from avoiding the full range of possible outcomes before making a decision.
