Behavioral Finance and Your Portfolio. Michael M. Pompian
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emotions, beliefs, or values; cognitive dissonance is a state of imbalance that occurs when contradictory cognitions intersect.
The term cognitive dissonance encompasses the response that arises as people struggle to harmonize cognitions and thereby relieve their mental discomfort. For example, a consumer might purchase a certain brand of mobile phone, initially believing that it is the best mobile phone available. However, when a new cognition that favors a substitute mobile phone is introduced, representing an imbalance, cognitive dissonance occurs in an attempt to relieve the discomfort that comes with the notion that perhaps the buyer did not purchase the right mobile phone. People will go to great lengths to convince themselves that the mobile phone they actually bought is better than the one they just learned about, to avoid mental discomfort associated with their initial purchase. In essence, they persist in their belief that they are correct. In that sense, cognitive dissonance bias is the basis for all of the belief perseverance biases in this section with different variations on the same theme.
Example of Cognitive Dissonance
Smoking is a classic example of cognitive dissonance. Although it is widely accepted by the general public that cigarettes cause lung cancer and heart disease, virtually everyone who smokes wants to live a long and healthy life. In terms of cognitive dissonance theory, the desire to live a long life is dissonant with the activity of doing something that will most likely shorten one's life. The tension produced by these contradictory ideas can be reduced by denying the evidence of lung cancer and heart disease or justifying one's smoking because it reduces stress or similar benefit. A smoker might rationalize his or her behavior by believing that only a few smokers become ill (it won't be me), that it only happens to two-pack-a-day smokers, or that if smoking does not kill them, something else will. While chemical addiction may operate in addition to cognitive dissonance for existing smokers, new smokers may exhibit a simpler case of the latter.
This case of dissonance could also be interpreted in terms of a threat to the self-concept.1 The thought, “I am increasing my risk of lung cancer,” is dissonant with the self-related belief, “I am a smart, reasonable person who makes good decisions.” Because it is often easier to make excuses than it is to change behavior, dissonance theory leads to the conclusion that humans are sometimes rationalizing, and not always rational beings.
Implications for Investors
Investors, like everyone else, sometimes have trouble living with their decisions and they often go to great lengths to rationalize decisions on prior investments, especially failed investments. Moreover, people displaying this tendency might also irrationally delay unloading assets that are not generating adequate returns. In both cases, the effects of cognitive dissonance are preventing investors from acting rationally and, in certain cases, preventing them from realizing losses for tax purposes and reallocating at the earliest opportunity. Furthermore, and perhaps even more important, the need to maintain self-esteem may prevent investors from learning from their mistakes. To ameliorate dissonance arising from the pursuit of what they perceive to be two incompatible goals—self-validation and acknowledgment of past mistakes—investors will often attribute their failures to chance rather than to poor decision making. Of course, people who miss opportunities to learn from past miscalculations are likely to miscalculate again, renewing a cycle of anxiety, discomfort, dissonance, and denial.
Both selective perception (information distortion to meet a need, which gives rise to subsequent decision-making errors) and selective decision making (an irrational drive to achieve some specified result for the purpose of vindicating a previous decision) can have significant effects on investors. Box 3.1 illustrates four behaviors that result from cognitive dissonance and that cause investment losses.
BOX 3.1 Cognitive Dissonance Bias: Behaviors That Can Cause Investment Mistakes
1 Cognitive dissonance can cause investors to hold losing securities positions that they otherwise would sell because they want to avoid the mental pain associated with admitting that they made a bad decision.
2 Cognitive dissonance can cause investors to continue to invest in a security that they already own after it has gone down (average down) to confirm an earlier decision to invest in that security without judging the new investment with objectivity and rationality. A common phrase for this concept is “throwing good money after bad.”
3 Cognitive dissonance can cause investors to get caught up in herds of behavior; that is, people avoid information that counters an earlier decision (cognitive dissonance) until so much counter information is released that investors herd together and cause a deluge of behavior that is counter to that decision.
4 Cognitive dissonance can cause investors to believe “it's different this time.” People who purchased high-flying, hugely overvalued growth stocks in the late 1990s ignored evidence that there were no excess returns from purchasing the most expensive stocks available. In fact, many of the most high-flying companies are now far below their peaks in price.
Am I Subject to Cognitive Dissonance Bias?
This test begins with a scenario that illustrates some criteria that can determine susceptibility to cognitive dissonance.
Cognitive Dissonance Bias Test
Scenario: Suppose that you recently bought a new car, Brand A, Model B. You are very pleased with your purchase. One day, your neighbor finds you in your driveway washing your new car and comments on your new purchase: “Wow, love the new car. I know this model. Did you know that Brand Y, Model Z (Model Z is nearly identical to Model B), was giving away a free navigation system when you bought the car?”
You are initially confused. You were unaware, until now, that Model Z was including a navigation system with purchase of the car. You would have liked to have it. Perhaps, you wonder, was getting Model B a bad decision? You begin to second-guess yourself. After your neighbor leaves, you return to your house.
Question: Your next action is, most likely, which of the following?
1 You immediately head to your home office and page through the various consumer magazines to determine whether you should have purchased Model B.
2 You proceed with washing the car and think, “If I had it to do all over again, I may have purchased Model Z. Even though mine doesn't have a navigation system, I'm still pleased with Model B.”
3 You contemplate doing some additional research on Model Z. However, you decide not to follow through on the idea. The car was a big, important purchase, and you've been so happy with it—the prospect of discovering an error in your purchase leaves you feeling uneasy. Better to just put this thought to rest and continue to enjoy the car.
Test Results Analysis
Answering “c” may indicate a propensity for cognitive dissonance. The next section gives advice on coping with this bias. Does this make sense?
Investment Advice
The investment advice presented here is primarily preventative. People who can recognize cognitive dissonance in action and prevent it from causing mistakes become much better investors. Specifically, there are three common responses to cognitive dissonance that have potentially negative implications for personal finance and, consequently, should be avoided:
1 modifying beliefs,
2 modifying actions, and
3 modifying