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Cognitive dissonance & investing

Jun 12, 2008

What is ‘cognitive dissonance’?
The theory of cognitive dissonance states that when we hold two conflicting beliefs in our minds, the discomfort caused by this conflict drives us to acquire, or even invent, new thoughts or beliefs, or even modify current beliefs, in an attempt to relieve the underlying conflict. Cognitive dissonance explains how and why people change their ideas and opinions to support situations that do not appear to be healthy, positive, or normal. Cognitive biases are one of the most important sources of erroneous economic or financial decisions. Cognitive dissonance causes people to rationalise actions taken while making financial or stock market related decision that differ from their own preferences.

So what has it to do with investing?
Cognitive dissonance initiates a form of self-deception, and this occurs in the world of investing too. So often, investors buy stock and upon learning subsequent information contrary to their original view, they distort, manipulate or ignore this new information so as to relieve the discomfort caused by the conflicting views in their heads.

The unwillingness to sell bad stocks is one of example of cognitive dissonance in stock market. An investor purchases a stock and then gets emotionally attached to the same. Consequently, he starts taking in only selective information and concentrates more on positive news and views about that particular stock, and selectively ignores bad news and views about the same. He comes up with reasons not to sell a stock like – "I have lost a lot of money and I would be punishing myself right now by selling it", or "It seems cheap to hang on to a loser."

  • Towards an investing framework

    Situations like these occur because an individual is distressed by the discrepancy between practical evidence and past choice, and he alters his beliefs to reduce this discomfort. The key feature of dissonance is that individuals alter their beliefs to conform to past actions.

    To deal with cognitive dissonance, one should follow strict discipline in investing. The Journal of Portfolio Management (by Christopher Faugere, Hany A. Shawky, and David M. Smith) indicates that, during the ‘bearish’ months from April 2000 to December 2002 in the US, investors who fared the best relative to their market benchmarks, were those who followed restrictive rules that did not allow much leeway for hanging on to stocks for emotional reasons.

    Thus it is imperative that investors should have some kind of selling discipline than having none. Without any kind of strategy, emotions will come into play, which can lead you to make wrong decisions.

    It is very critical for an investor to constantly re-evaluate his investments and views and change them as situations require and new data becomes available. It is inevitable that investors are going to make mistakes when forecasting the future. The good investors will minimise the financial damage done by such errors and the poor investors will fail to minimise the damage and this can lead to a small number of errors causing large losses.

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