How Information Bias Can Lead to Poor Investing Decisions

What Is Information Bias? 

Information bias occurs when information or data obtained by someone is measured or recorded incorrectly such that it no longer accurately reflects the underlying truth. This bias can be the result of a simple error in data collection or information processing, be caused by deliberate distortion, or arise from a subconscious tendency to filter information to meet one’s needs or conform to preexisting beliefs.

Information bias can significantly affect an investor’s decision making, leading to anywhere from less-than-ideal to dangerous investment choices. This is because human beings are naturally predisposed toward confirmation bias (when we seek out and prioritize information that fits our preconceived notions while dismissing contradictory evidence) and recency bias (when newer, more salient information is given more weight than it might really have), among others.

In today’s age of social media and constant connectivity, it is more important than ever to be aware of the types of information we receive and how they can help or hinder investment decisions and financial outcomes.

Information Bias and Investing

Information bias can lead investors to make bad decisions based on faulty data, or to seek out and rely on irrelevant or excessive information when choosing among market moves. The proliferation of social media has made it easier than ever to access vast amounts of information from all sorts of sources, making information bias a critical issue.

Information bias can negatively affect an investor’s decision making; for example, someone may place undue importance on a single news article or tweet, ignoring the broader context of a company’s performance or the market as a whole. Or an investor may seek out information that confirms already-held beliefs about a company or the broader market and ignore or downplay contradictory evidence.

Some types of information used by investors may not be as relevant to trading decisions as they might seem. For instance, day-to-day fluctuations in stock prices are often influenced by external factors such as broad market sentiment, which may not necessarily reflect a specific company’s long-term prospects.

Similarly, a company’s past performance may not be a reliable indicator of its future performance, as business environments and circumstances change and evolve over time.

Research has shown that investors who focus on relevant information and avoid information bias can make better investment decisions. For example, a study by behavioral economists Brad M. Barber and Terrance Odean found that individual investors who traded less frequently and paid less attention to stock market news achieved better returns than those who traded more frequently and paid more attention to the news.

Three Common Information Biases

• Recency bias, also known as availability bias, is a cognitive error identified in behavioral economics in which people incorrectly believe that recent events will occur again soon. By weighting recent information more, they also discount relevant information that is older or harder to obtain.
• Confirmation bias is the tendency of human beings to actively search for, interpret, and retain information that matches their preconceived notions and beliefs. At the same time, information that goes against these beliefs is discounted or ignored entirely.
• Asymmetric information occurs when one party to a transaction has more or better information than the other. For example, used-car sellers typically know more about the car than the buyer, or insurance policy applicants know more about their health than insurers. Asymmetric information can, in some cases, lead to market failure.

How to Avoid Information Bias in Investing

To avoid information bias in investing, consider the following tips and strategies:

• Limit exposure to financial news and social media: While staying informed is essential, too much exposure to financial news and social media posts can increase the risk of information bias. Be selective and objective about the sources you follow, and set aside specific times to check the news.
• Diversify your information sources: Obtaining news and information from a variety of sources, including those that you tend to agree with and those that you tend not to, can help mitigate the impact of any single piece of information on your overall investment strategy and provide greater balance.
• Base decisions on objective analysis: Focus on the underlying financial health and business prospects of a company, rather than short-term market fluctuations or news events. Keep your long-term investment objectives in mind when making decisions, and avoid being swayed by emotions like fear or greed.
• Seek professional advice: Consult with a financial advisor or investment professional who can help you make well-informed investment decisions.
  

Information Bias and the ‘Market for Lemons’

The information bias in the “Market for Lemons” refers to the fact that asymmetric information can lead to market failures. The idea was first introduced by economist George Akerlof in his widely cited 1970 paper, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” In his paper, a “lemon” refers to a used car with hidden defects that only the seller knows about, not the buyer.

This concept can be extended to other markets where the quality of goods is uncertain. The information bias in the lemons problem stems from the fact that sellers have more information about the quality of their goods than buyers do. As a result, buyers face uncertainty about the true quality of the goods they are purchasing, and they may be unwilling to pay a higher price for what they perceive as potentially low-quality goods.

The Bottom Line

Biased information is data or information that doesn’t accurately reflect the true state of the world. Information can become biased for several reasons, including mistakes in its collection or analysis, subconscious predilections when obtaining information, or deliberate distortion.

In behavioral economics, confirmation bias, recency (availability) bias, and asymmetric information are all information biases that can negatively influence investors’ decisions. Staying objective, obtaining information from a wide range of sources (including contradictory evidence), and soliciting the advice of others can help minimize these possible negative effects.