Confirmation Bias

Confirmation bias is the cognitive bias due to which investors tend to seek out information that supports their preferences and ideas, while tending to subconsciously ignore information which negates their conclusions. Consequently, investors end up investing in situations which are not completely ideal.

For example, consider an investor who is looking to invest in the renewable energy space and thinks that Company 'X' might be a good stock to buy. He looks at the projected growth of the wind power industry, the forecasts for high oil prices which re-inforce his view that wind power is a high growth industry, and also looks at X's rapid growth and order book. He reaches the conclusion that X definitely an idea worth investing.

While he is still conducting his research, he has become emotionally invested in the idea due to the amount of time he has spent researching X. Now he encounters an article which suggests that while X very good prospects, its debt burden is a problem. The interest outgo as well is a strain on its financials, and is likely to impact earnings, which in turn will impact the stock price.

This is where confirmation bias kicks in. Due to his emotional commitment and the amount of previous research he has done, he is convinced that the possibility of the debt burden leading to financial difficulties is limited and hence he dismisses the issue.

The end result is a bad investment which comes back to bit our investor when the market sentiment shifts and the investment community starts to fret over X's debt burden. This is a recipe for a dramatic stock price collapse.