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Shortly after the tulip bulb was introduced to Europe from the Ottoman Empire it found favor with Dutch high society. The humble tulip bulb rocketed in price. At the height of the mania one tulip bulb was equivalent to ten times the income of a skilled worker. This tulip mania or bubble which took place in the Netherlands from 1634 to 1637 is associated with a herd mentality. The overconfidence which occurred during the tulip boom was a result of individuals actively assigning weight to circumstances while ignoring evidence and fundamentals. This limitation of the human psyche contributes to overconfidence in one’s personal beliefs about some event or circumstance. This confirming bias can appear in economic and political systems as well as businesses, organizations, and social systems. This tendency to interpret information can manifest itself in economic bubbles known as speculative bubbles. Bubbles have long been influential in shaping economies and impacting societies.
Impacts in Finance, Investing, and Business
Confirmation bias can lead investors, businesses, and organizations to be overconfident in their views and decision making. People ignore relevant evidence in favour of information that supports their original views. A recent study of how information from virtual communities, such as stock message boards, influences investors’ trading decisions and investment performance was examined with an analysis of 502 investor responses. The study showed how investors use message boards to seek information which confirms their prior beliefs in relation to a stock. Confirmation bias confirms current views, making investors overconfident, adversely affecting their investment performance. The study demonstrated investors exhibit confirmation bias when they process information from message boards. The study also demonstrated investors with stronger confirmation bias exhibit greater overconfidence. They have higher expectations about their performance and trade more frequently, but obtain lower realised returns. (1)
Bubbles are a Result of Confirmation Bias
The history books are littered with examples of businesses, ideas, and manias that have promised the world and delivered nothing. This tendency to interpret information can manifest itself in economic, financial, or asset bubbles known as speculative bubbles. From Railway Mania which swept the United Kingdom in the 1840s, to the Florida Real Estate Bubble of the early 1920s, to the Great Depression, asset bubbles have become a regular feature of modern society. Following on from the Florida Bubble, the stock market crash of 1929 was another bubble which popped after the ‘Roaring Twenties’ economic boom. The markets soared during times of peace and prosperity with new technologies such as radio, the automobile, and airplanes becoming commercialised. Americans speculated in the stock market, often with borrowed money. By October of 1929, the stock market peaked then plummeted. Thousands of banks failed and unemployment skyrocketed, signalling the beginning of ‘The Great Depression.’ Bubbles have long been influential in shaping economies and impacting societies.
All Bubbles Burst
In the late 1980’s the Japanese ‘Bubble Economy’ collapsed. The bubble episode was characterized by rapid acceleration of asset prices and overly exuberant economic activity, as well as an uncontrolled money supply and credit expansion. The Japanese post-war economic boom saw both stocks and real estate assets increase significantly until late 1989 when the tide turned. Japan’s economy deflated and many assets halved almost overnight. The succeeding decades saw Japanese assets continue to deflate as the economy struggled to deal with the massive deleveraging of assets. A more recent example of bubbles was the Dot-com Bubble, which was another speculative bubble in the early years of the internet. Excessively high business valuations combined with pure speculation drove stocks to spectacular levels in a very short time. The NASDAQ plunged from 5000 to 1000 by 2002, sending the U. S. economy into a recession.
The Biggest Bubble of Them All
According to the Financial Times, currently, 99 global companies have defaulted since the year began, the second greatest tally in more than a decade and only exceeded by the financial crisis which saw 222 defaults in 2009, according to Standard & Poor’s. US companies account for 62 of this year’s defaults. Investors have become increasingly concerned about the state of the credit market, reflecting how companies have borrowed heavily against the backdrop of low interest rates during the era of easy money. Since 2007, the proportion of corporate bonds S&P has rated speculative-grade, or junk, has climbed to about 50% from 40 percent. Now, as markets anticipate the Federal Reserve will lift interest rates for the first time in almost a decade, the rise in defaults suggests a number of companies are being challenged by a sluggish operating environment, declining revenues, and heavy debt loads. (2)
McKinsey and Company released a report earlier this year which highlighted that since the GFC, a mere seven years ago, global debt continues to grow. All major economies today have higher levels of borrowing relative to GDP than they did in 2007. Global debt in these years has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points. (3)
Confirmation Bias IS NOT Limited to Business
Our tendency to look for corresponding and confirming information enables us to live with consistency, which gives us comfort. These confirming beliefs, however, lead us to make errors of judgement. This bias is embedded deep within us all and prevalent throughout society. We selectively recall and interpret ambiguous sources of information which support our existing position, making us overconfident in our assumptions and open to statistical bias and manipulation. Is it little wonder there is so much misinformation, bias, and confusion around many issues facing individuals and society. Some notable belief distortions include:
- The Climate Change Debate
- Israeli / Palestinian Conflict
- Over Population
- Genetic Modification
- Pesticide Use
- Resource Depletion
- Wifi Impacts
- Nuclear Energy
We Are All Biased in Some Way, Shape, or Form
Over the centuries societies have made erroneous decisions based on beliefs, half-truths and indoctrination, these failures stem from the inability to objectively assess the reality that exists. We ignore the facts and unfavourable information in the search of information which supports our view and makes us feel good. Our ability to ignore relevant evidence in favour of information that supports our original views is hampering humanity. While we seek to confirm we are right, we are only setting ourselves up for failure. Until we think critically and overcome our biases we will always struggle to reach our true potential — a world of harmony, peace, and connection with all that exists…
It’s time to Rethink…
excerpts from Rethink…Your world, Your future.
(1) JaeHong Park, Prabhudev Konana, Bin Gu, Alok Kumar, Rajagopal Raghunathan, Confirmation Bias, Overconfidence, and Investment Performance: Evidence from Stock Message Boards, http://misrc.umn.edu/wise/papers/p1-3.pdf