Cognitive Dissonance and Its Effect on Investment DecisionsSubmitted by NFG Wealth Advisors on May 1st, 2018
The internet is changing the way we are acquiring information to make sound investment decisions. There was a time when we were completely dependent on print resources and full-service brokers for seeking advisory services or individual stock ideas. However, we are now increasingly relying on online resources and electronic networks to access financial reports and other relevant data to improve our portfolio returns. Meanwhile, technological innovation has empowered us to research stocks and compare investment strategies using online tools and arguably make better investment decisions.
However, stock markets often behave unpredictably partly because many investment decisions are influenced more by investor psychology and less by analytical tools – despite their ubiquitous availability. In the absence of perfect information, cognitive factors and emotional issues play a greater role in impacting our decision-making process. Over a long enough time-horizon, even the most experienced investors might make make irrational decisions after falling victim to various cognitive biases.
Of all the behavioral biases studied in the field of behavioral finance, cognitive dissonance bias has been one of the most important causes of erroneous investment decisions and as wealth advisors, we not only have to deal with it within our own process but manage it when it affects our clients.
What is Cognitive Dissonance Bias?
Cognitive dissonance is the psychological discomfort that is experienced by harboring two conflicting ideas, opinions, beliefs or attitudes. Think back to a time when you invested in a stock only to see it decline after the company reported worse than expected earnings and negative guidance. That uncomfortable feeling in your stomach is the result of the conflict between what you originally thought was a great investment, and this 'new information' that contradicts with that view.
A person experiencing dissonance seeks to reduce the mental distress by means of incorrect and biased thoughts and actions that are often self-justifying. We might discount that recent report as a blip in the company's otherwise promising prospects or the stock's decline as an overreaction by 'the market' – all those other irrational investors that don't see what we see in the stock.
The case of a smoker who fails to quit smoking can be considered a good example to understand cognitive dissonance. A smoker experiences cognitive dissonance when he continues to smoke even after being aware that the habit is injurious to health. The smoker tries to reduce the dissonance by altering generally accepted beliefs. He or she might justify the irrational behavior by citing the example of a chain smoker who has remained healthy or by convincing himself that it is a great stress-reliever. The smoker may also refrain from reading literature that contradicts his viewpoints or come up with other reasons why 'that won't happen to me'.
The degree of dissonance you may experience also depends on the strength of your belief system and the level of inconsistency between the two contradictory beliefs. Everyone is susceptible to cognitive dissonance and the unpleasant emotions like guilt, shame , or discomfort that are often accompanied by a strong urge to either ignore any new information or interpret the information in a biased way.
How does cognitive dissonance bias impact investment decisions?
In the domain of behavioral finance, the study of cognitive dissonance has gained importance due to the way it impacts our investment decision-making capabilities. We all experience cognitive dissonance when the stock market acts in a way that contradicts our beliefs. In an attempt to harmonize our emotions, we may continue to hold stocks that we would otherwise sell because we wish to avoid the discomfort of admitting that we made a bad decision. We may also continue to irrationally invest in the stocks we already own even after their price has gone down to conform with our earlier decision to invest in that security. This type of irrational behavior is dangerous because it may cause us to hold on to our favorite stocks even after disconfirming facts are available.
Cognitive Dissonance can also stimulate us to abandon our existing beliefs to reduce psychological conflict. It is easy to fall in the cognitive dissonance trap when we impulsively buy a stock whose price unpredictably jumps while it is expected to fall down. Going along with the short-term market reaction might reduce the dissonance temporarily but the absence of proper due-diligence exposes us to higher risks. Thus, any dissonance-reducing impulsive behavior turns us from a long-term investor into a short-term speculator. That might be OK for some of us, but investors who manage to overcome this cognitive bias stand a greater chance of maximizing returns in the long run.
Overcoming Cognitive Dissonance Bias
Being objective and analytical in our decision making will help us overcome cognitive biases. Changing beliefs and letting go of biased attachments is undoubtedly the surest way to overcome cognitive dissonance – especially when new information calls for a 'reality-check'. However, it is extremely difficult to do as our attitudes, values and beliefs largely depend on our personality, life experiences and genetic makeup. In that case, the best way would be to identify and eliminate emotional triggers that stimulate subjective decision making.
One way to do this is to develop a repeatable investment process with rules that will trigger an action irrespective of emotion – like setting up ‘stop-loss’ and ‘take profit’ levels. That way if the stock drops below that stop loss level it would automatically be sold. Some traders will argue that this could lead to missing out on a quick bounce in the stock after the stop loss was triggered. Yes, that is true, but it could also help an investor get out of a stock that might continue to decline.
Either way, when the stop loss is triggered, its time to evaluate the position to determine whether to stay out of the position or get back in. This will force an investor to think about whether they are willing to pay the current price to invest in the stock, rather than struggle with whether to sell the stock at a loss while struggling with dissonance. Personally, I like to set trailing stop losses. That way, as the stock appreciates, the stop loss price resets along with it. The percentage of the trailing stop loss is based on the volatility of the stock. The higher the volatility, the higher the percentage drop required to trigger the stop loss.
We should also be receptive to relevant data sources that will help us confirm our doubts or fears. Instead of favoring a select few data sources as investors, we must refer to additional sources of information to re-evaluate our portfolio. In fact, I often seek out sources with views that directly contradict my own – giving me a much deeper perspective of the company or opportunity I'm evaluating.
Lastly, erroneous information must be eliminated and new information must be assessed objectively. We all make mistakes. The new piece of information may serve to shed more light on the unpredictable behavior of the stock market during emotionally charged times and how it might adversely impact our holdings. Don't ignore this information.
With so much information at our fingertips, it is easy to assume that we should all be making better investment decisions. But more information sometimes can be overwhelming, so we tend to gravitate towards information we are comfortable with or is easily attainable. That is, until new information shoots a hole in our thesis for buying a stock. Unfortunately, more information doesn't mean perfect information and too often the information we rely on to make an initial investment decision is considered sacrosanct. So much so that when contradictory information comes to light, we too easily discard it because of the uncomfortable feelings it instills in us. In my opinion, however, it is better to deal with the feeling of being wrong and losing a little bit of money, than to stick to your guns and deal with the feeling of losing a lot of money. Investors that can properly recognize and overcome this psychological trap, therefore, will become better investors in the long run.