How Confirmation Bias Warps Market Thinking

We've all been there—finding a chart that agrees with our view, a quote that supports our take on inflation, or a backtest that vindicates our strategy. But when we start investing based on validation rather than investigation, we're no longer allocating capital—we're allocating confirmation. At Quantlake, we believe a systematic, long-term ETF approach can help mitigate these tendencies. But to do so effectively, we first need to understand what confirmation bias looks like in the markets—and how to catch ourselves when it shows up.

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🧠 What Is Confirmation Bias, Really?

Confirmation bias is the tendency to seek, interpret, and remember information in ways that affirm our pre-existing beliefs. It's not just about being opinionated—it's about subconsciously filtering reality. As Raymond Nickerson (1998) summarized, this bias is "ubiquitous" across human reasoning and especially persistent in ambiguous environments—like financial markets​.

For investors, this might mean overweighing bullish headlines when holding equities or dismissing macro data that contradicts our rate expectations. It can manifest in research, portfolio decisions, or even in the way we read performance reports.

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📊 The Evidence in Market Behavior

One of the clearest signs of confirmation bias in markets is the persistence of the disposition effect—the tendency to sell winners too soon and hold onto losers too long. Terrance Odean's (1998) study of 10,000 brokerage accounts found that investors realized gains more readily than losses—even though the sold winners went on to outperform the held losers​. Why? Investors often hold onto losing positions not just because of hope, but because they selectively interpret data as confirming their belief in an eventual recovery.

This also connects to prospect theory (Kahneman & Tversky, 1979), which shows that people are risk-seeking in the domain of losses—they don't want to lock in a loss and will search for any evidence to justify holding on.

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📈 Analysts, Forecasts, and Belief Overreaction

Even professionals are not immune. Bordalo et al. (2020) analyzed long-term earnings expectations for S&P 500 firms and found systematic overreaction to good news—especially among high-growth stocks. When analysts revise upwards, markets price in not only the new data but also inflated beliefs about future growth. These stocks later underperform, suggesting that expectations were more about narrative than fundamentals​.

Such behavior aligns with what behavioral economists call "belief-based mispricing," where asset prices reflect collective overconfidence rooted in cherry-picked data. The result? Short-term euphoria, long-term disappointment.

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💻 Digital Markets and the Amplification of Bias

The internet—and especially algorithmically curated feeds—can amplify confirmation bias. In Barber and Odean's (2001) research on online investors, they found that after switching from phone-based to internet-based platforms, investors traded more speculatively and underperformed by about 6% annually​.

Online access doesn't just lower trading costs; it also increases exposure to biased sources and echo chambers. In environments flooded with choice, investors tend to gravitate toward familiar narratives. As Iyengar and Kamenica (2010) showed, when faced with large fund menus, investors choose simpler, emotionally comforting options—even if they aren't optimal​.

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🚩 How Confirmation Bias Sneaks into Our Portfolios

At Quantlake, we see several patterns where confirmation bias can subtly affect ETF investors:

• Backtest Anchoring: Investors often favor strategies with strong historical performance, even when forward-looking assumptions have changed. If a portfolio had a great 2020, investors might attribute its success to skill, not circumstances—especially if it matches their beliefs.
• Headline Reliance: News flow can shape sentiment more than fundamentals. Tetlock (2007) found that media pessimism led to short-term price drops, followed by reversion. Investors reacted not to data, but to mood​.
• Confirmation via Community: In investing forums, social validation often trumps analytical rigor. When others share our view, we feel more confident—even if the underlying data is weak. This is especially common with thematic ETFs and trend-chasing behavior.

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🛠️ Mitigating the Bias: From Belief to Process

Systematic investing doesn't eliminate biases—but it helps constrain their influence. Here's how we think about counteracting confirmation bias:

🔍 Separate Signal from Narrative

Quantitative strategies based on long-term data and rebalancing rules can help guard against the pull of emotionally charged stories. Vanguard's own research emphasizes that sticking to a target allocation—rather than chasing performance—is key to risk control over return chasing​.

⚖️ Use Disconfirming Evidence as a Signal

Actively seek out reasons why you might be wrong. If you're bullish on a sector, read neutral or bearish analyses. Professional forecasters often fail during inflection points precisely because they don't challenge their frameworks​.

🔄 Systematize Rebalancing

The more discretion we allow ourselves in rebalancing portfolios, the more room we give confirmation bias to sneak in. A rules-based approach helps maintain discipline without overreacting to noise​.

📝 Track Decision Context

Journaling investment decisions—including what data was used and what was ignored—can help build metacognitive awareness. As Dunning and Kruger (1999) showed, improving one's judgment often starts with realizing how fallible it is​.

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📌 The Bottom Line

Confirmation bias isn't just a psychological curiosity—it's a portfolio risk. By relying on systematic processes, diversifying information sources, and scrutinizing our own assumptions, we can shift from belief-driven investing to data-aligned decision-making. At Quantlake, we're not just building ETF strategies—we're building behavioral resilience.

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Happy Long-Term Investing!

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