How Tunnel Vision Leads to Poor Money Decisions
How to avoid the pitfalls of confirmation bias when making money decisions
“Confirmation bias is the most effective way to go on living a lie.”
- Criss Jami
This is another installment in my ongoing series called “Money On My Mind,” where I publish articles to help you deal with the psychological aspects of managing money. Check out past editions of the series here.
Today we begin exploring cognitive biases, a term used to describe the unique ways the human brain struggles to process complex information, which leads to irrational decision-making.
Continue reading to learn:
What confirmation bias means
Three specific ways in which confirmation bias impacts how you interpret new information
How confirmation bias leads to sub-optimal financial decision making
What causes confirmation bias and, most importantly, how to avoid it
Confirmation bias keeps you in tunnel vision
Confirmation bias is the tendency to seek out and interpret new information in such a way that reinforces their prior belief. It’s why people can’t seem to agree on, well, anything, even basic facts.
Confirmation bias can impact your thinking in three ways.
First, confirmation bias influences the information you look for.
If you hold a strong belief that day trading is the most effective way to build wealth, your Google search history would be filled with queries like “how to make money day trading.” What will be absent from your search history are questions like “do day traders actually make money?”
Second, confirmation bias warps how you interpret neutral or contradictory information presented to you.
Confirmation bias goes beyond seeking out information that reinforces our prior beliefs. Our need to be right is so ingrained that we tend to interpret any information presented to us in such a way that allows us to maintain those prior beliefs.
In my book, “The Rational Investor,” I spent 278 pages presenting evidence that investment tactics like stock trading are a complete waste of time and money and that the rational way to invest is to build a portfolio of globally diversified index funds.
If you held no particularly strong viewpoint on investing before reading the book, you might be persuaded by the mountain of evidence I point to showing the futility of trying to “beat the market.” However, if, before buying the book, you were fully bought in on the idea that trading stocks is the most reliable way to build wealth in the stock market, you would probably look something like this while reading the book.
It wouldn't matter how many studies I point to that show day traders are more likely to lose money than outperform the average return of the market; you would find a way to poke holes in the arguments and explain away what the data tells us.
During the meme-stock craze of 2021, I distinctly remember seeing multiple Tweets from men in their early 20s saying, “Warren Buffett had a good run, but he just doesn’t get how the stock market works in modern times.” Just, wow.
Third, confirmation bias distorts your memories.
A 2021 paper titled "Investor memory of past performance is positively biased and predicts overconfidence" compared individual investors' actual returns to the returns they reported from memory.1 Investors in the study consistently remember having greater investment returns than they actually experienced. The researchers also found that the more often an investor traded stocks, the more likely they were to overstate their investment returns.
That’s confirmation bias distorting your memory. If you believe you are great at trading stocks, you’re more likely to overinflate your investment returns—either consciously or subconsciously.
People hate to be wrong and especially hate to be wrong about money.
Two more examples of how confirmation bias impacts financial decision making
Example 1: How you work
As I’ve written in the past, the most important financial decision you’ll ever make is how you choose to make money.
The two most important assets in life are:
Time and;
Money
What line of work you do and whether you choose to be a 9-5 employee or business owner will dictate how much money you earn in your life and how you spend the majority of the working hours in the prime years of your life.
If you have preconceived notions of what the “right” way to make money is, you’ll set yourself up for disappointment.
I once wrote that no group of people in society were deified more than entrepreneurs. I’d like to amend that statement; no group of people in society is more deified than solopreneurs— or the “1 person” business.
I am an example of a solopreneur. I am a one-man business that runs a personal finance website (the one you’re reading) and publishes books on investing and personal finance. Apart from my wife, who helps with graphic design and proofreading, it’s just me running Making of a Millionaire.
Influencers would have you believe solopreneurship is effortless, mega-profitable, and glamorous. I am here to tell you that it’s hard as hell, profits are volatile, and there’s little glamor in the work that goes into keeping this ship afloat.
But if you feel; in your bones that solopreneurship is the best way to make money, then you’d be likely to ignore people who tell you that running a one-person business is not all it’s cracked up to be.
If you start a solo business as a side huslte, then all you risk losing is time, and whatever startup costs are required.
If you dive in feet first and make a solo business your full-time job, things can get ugly quickly. Most businesses fail, and most solopreneurs never crack $1,000 in monthly income.
This isn’t so bad if you have a lot of money to fall back on or a spouse who makes enough to cover your living expenses. But if you are the breadwinner in the family, quitting your job to go full-time in a business can be devastating if the business goes belly up.
Successful entrepreneurs and solopreneurs usually fall into one of two camps:
Rich people who have the luxury of going without income for an extended period of time.
Hustlers who maintain their business as a side hustle, working two full-time jobs until the business is making steady profits.
It’s not just a bias toward entrepreneurship. Many people believe the only way to get ahead is to get a 4-year degree, so they are willing to take on six figures in debt to make that happen.
Many people’s career choices are guided by confirmation bias, never stopping to consider if they might make more money or be happier doing another type of job. As a result, they leave money on the table and spend too much time doing work they don’t like.
Example 2: Whether you rent or buy your home
The eternal debate in personal finance is whether it makes more financial sense to rent or buy your home.
There are two schools of thought on rent vs. buy.
The ownership crowd who believes that owning a home is better than renting. The central argument here is that paying rent is throwing your money away. You’ll often hear arguments from this crowd like “paying rent is simply paying someone else’s mortgage.”
The renting crowd believes that renting a home is better than owning one. The central argument here is that a house isn’t really an investment. You’ll often hear arguments from this crowd like, “a house costs you money, and therefore it should be treated like a liability rather than an asset.”
This debate will literally rage on for eternity in large part-thanks to confirmation bias.
Few financial decisions are as emotionally loaded and consequential as deciding what kind of home you want to live in and whether you rent or buy. So, many people are so deeply entrenched in their view that those in the ownership camp will never consider renting, and those in the renting camp will never consider buying.
The reality is that there is no universal right answer, so refusing to consider the opposing viewpoint can be very costly. From a financial perspective, renting vs. buying is about answering three questions.
How much does a home in your area cost to buy?
How much does a comparable home cost to rent in the same area?
If renting turns out to be cheaper, what will you do with that extra cash?
A) Determining the cost to buy a home, you need to factor in all the upfront costs—down payment, taxes, legal & realtor fees, etc.— and all the ongoing costs—property taxes, mortgage payments, insurance, utilities, maintenance, homeowners association fees.
B) The cost to rent a home is more straightforward; damage deposit + monthly rent + utilities + renters insurance.
Then the question for renters is if B < A, what will you as a renter do with the extra money?
Your rent payments are not going to pay down the principal of a mortgage. This is a point the homeownership crowd uses to say, “AH HA! See, owning is always better!”
Except, that’s not inherently true. A renter can still build more wealth than an owner in the long run if they use the money they saved as a renter and redirect it to investments. See the post below for an explanation of this using the “5% Rule.”
What causes confirmation bias?
A 1998 paper titled "Confirmation Bias: A Ubiquitous Phenomenon in Many Guises" written by Raymond Nickerson offers a few possible explanations. 2
The first explanation is that our brains find it easier to process information that supports what we already believe to be true. It’s easier and more likely for our brain to highlight and interpret information that supports our pre-existing beliefs, whereas our brain might be quick to label evidence contrary to our belief as “Wrong.” Oftentimes we may not even be aware this is happening.
Another possible explanation offered by Nickerson is that our brains are lazy. To quote Nickerson’s 1998 paper: