First impressions count, but, unfortunately for many investors, they may count too much. The human tendency to rely on first impressions and stick with them despite later evidence to the contrary has been dubbed “confirmation bias” by cognitive researchers. It is a form of mental shortcut that allows us to make decisions when faced with a lot of information. However, it also may force us to rely on the wrong information and to ignore good information that may help us later.
Many psychological experiments have identified confirmation bias as being widely held. They found that as soon as someone develops a preference they would filter new information in a way to support that preference. New information that contradicts the preference will be ignored or discounted. They also found that once someone has developed a feeling about something it becomes much harder to overcome the bias created by that feeling. Marketers and advertisers use this bias as the cornerstone of selling: if they can make a positive first impression, they are more likely to make a sale.
How does this affect investors? Suppose you buy a stock for whatever reason—a tip, research you have done, or you just like the company’s products. Immediately the stock starts going up and has a great run for six months. Such action would “confirm” your decision. What if negative information started coming in, such as critical analyst reports, an accounting scandal, or a decline in your stock’s industry? For investors already confirmed in their beliefs in the stock, the new information most likely would be discounted: they would continue holding the stock because it was “good.”
Sound outrageous? Then consider the millions of investors who stuck with Internet and communications stocks from the late 1990s through the bear market. Many saw gigantic leaps in value in 1998 and 1999, only to see the stocks go into a freefall in the 2000-02 bear. Unfortunately, their early good experiences clouded their judgment and they couldn’t bring themselves to sell their stocks. Many held on until their stocks were worthless or nearly worthless because they discounted the price declines as temporary.
