While on holiday in Japan I picked up a copy of Thinking, Fast and Slow at the airport. The author Daniel Kahneman explores how human decision-making is shaped by two cognitive systems: System 1, which is fast, intuitive, and emotional, and System 2, which is slow, deliberate, and logical. While System 1 helps us make quick judgments and recognize patterns, it is also prone to biases and errors. System 2, in contrast, is more methodical but requires significant effort and energy to engage. And apparently humans are inherently lazy…surprise, surprise!
One of the key cognitive biases Kahneman discusses is confirmation bias, the tendency to seek out, interpret, and remember information that supports our pre-existing beliefs while ignoring contradictory evidence. This bias has profound implications for investing, where rational decision-making is crucial for success. Understanding how Kahneman’s two-system model contributes to confirmation bias can help investors avoid costly mistakes and make more objective financial decisions.
Investing often requires quick judgments, and System 1 plays a dominant role in these snap decisions. Because System 1 is driven by heuristics (mental shortcuts), it can cause investors to develop strong opinions about stocks, industries, or investment strategies based on limited or anecdotal information. Once an investor forms an initial belief, whether it’s that a particular company is a “sure bet” or that a certain sector is doomed, confirmation bias kicks in.
For example, suppose an investor is convinced that artificial intelligence (AI) will drive exponential growth in a particular stock. Instead of critically evaluating the company’s fundamentals, the investor might selectively absorb news articles, analyst reports, or social media posts that reinforce this belief. Any negative data, such as concerns about regulation, competition, or declining profit margins, is subconsciously dismissed, or rationalised away. This leads to overconfidence, another bias Kahneman and his collaborator Richard Thaler1 have studied extensively in behavioural finance. Overconfidence can result in excessive risk-taking, poor portfolio diversification, and a failure to acknowledge market uncertainties.
Confirmation bias also manifests in how investors interpret ambiguous data. If a company’s earnings report shows slowing revenue growth but strong profitability, an investor already bullish on the stock might focus only on the profit increase, while ignoring the revenue slowdown. This selective perception prevents objective analysis and can lead to holding onto losing investments for too long, a phenomenon related to the “endowment effect,” another concept Thaler popularized, where investors irrationally overvalue assets they already own.
A less discussed, but equally, damaging form of confirmation bias occurs when investors avoid entire industries or geographies simply because of past losses, even if those failures were due to other reasons other than structural industry flaws.
A current example of this bias at play is the likely reaction to the recent unicorn eFishery scandal in Indonesia. The collapse of the once-promising aquaculture business, due to governance issues and financial mismanagement, will likely discourage many investors from looking at Indonesia’s growth equity ecosystem or the aquaculture industry for some time. However, this reaction may be overly simplistic. The downfall of eFishery2 was due to mismanagement/fraud rather than fundamental flaws in aquaculture as a sector or Indonesia as an investment destination. Investors who can separate structural opportunity from specific failures may find attractive contrarian opportunities in precisely these areas.
System 2, when properly engaged, can help counteract confirmation bias by encouraging critical thinking and deeper analysis. Unlike System 1, which jumps to conclusions, System 2 is methodical and evidence based. However, Kahneman emphasises that System 2 is lies dormant, it does not naturally intervene unless we deliberately activate it.
For investors, engaging System 2 means:
As artificial intelligence advances, investment decision-making will increasingly be supported by machine-learning models that act as an investor’s augmented System 2, much like Tony Stark’s AI assistant J.A.R.V.I.S. in Iron Man. These AI-driven systems will enhance rational decision-making by processing vast amounts of data objectively, identifying patterns that human investors might miss, and challenging assumptions through automated counterarguments.
Instead of relying on intuition, investors will be able to run their hypotheses through AI models that can simulate market reactions, stress-test investment theses, and provide probabilistic outcomes based on historical and real-time data. AI could instantly scan thousands of financial reports, alternative data sources, and global news articles to highlight not only confirming but also disconfirming evidence, counteracting the natural tendency toward confirmation bias.
Additionally, AI’s ability to remove emotional influences from decision-making will help investors avoid knee-jerk reactions to market volatility. While human investors may panic during a crash or get caught up in speculative bubbles, AI-powered investment platforms can provide unemotional, probabilistic assessments of risk and reward, keeping portfolio decisions more disciplined.
Of course, AI itself is not immune to biases. It learns from historical data, but when used correctly, AI can serve as a powerful tool to enhance System 2 thinking; it does not replace human judgment. The best investors of the future will likely be those who leverage AI’s analytical power while maintaining a critical, sceptical mindset, ensuring that neither human biases nor algorithmic blind spots dominate the decision-making process.
So, will you use AI to bring more objectivity to your investment decisions, or will you let unconscious bias take the lead?
Sources: