Behavioral Finance and Your Portfolio. Michael M. Pompian
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1 Modifying beliefs. Perhaps the easiest way to resolve dissonance between actions and beliefs is simply to alter the relevant beliefs. When the principle in question is important to you, however, such a course of action becomes unlikely. People's most basic beliefs tend to remain stable; they don't just go around modifying their fundamental moral matrices on a day-to-day basis.Investors, however, do sometimes opt for this path of least resistance when attempting to eliminate dissonance (although the belief-modification mechanism is the least common, in finance, of the three coping tactics discussed here). For example, if the behavior in question was “selling a losing investment” that has little chance of recovering one might concoct a rationale along the lines of “it is okay not to sell a losing investment” in order to resolve cognitive dissonance and permit yourself to hold onto a stock. This behavior, obviously, may pose hazards to your wealth. Taking a tax loss and moving on is typically the best course of action in this scenario.
2 Modifying actions. On realizing that you have engaged in behavior contradictory to some preexisting belief, you might attempt to instill fear and anxiety into your decision in order to averse-condition yourself against committing the same act in the future. However, averse conditioning is often a poor mechanism for learning, especially if you can train yourself, over time, to simply tolerate the distressful consequences associated with a “forbidden” behavior.Investors may successfully leverage averse conditioning. For example, in the instance wherein a losing investment must be sold, an individual could summon such anxiety at the prospect of actually losing money. Again, taking a tax loss and moving on is a good solution. Even the best investors take losses and move on.
3 Modifying perceptions of relevant action(s). A more difficult approach to reconciling cognitive dissonance is to rationalize whatever action has brought you into conflict with your beliefs. For example, you may decide that while hitting a dog is generally a bad idea, the dog whom you hit was not behaving well; therefore, you haven't done anything wrong. People relying on this technique try to recontextualize whatever action has generated the current state of mental discomfort so that the action no longer appears to be inconsistent with any particular belief.An investor might rationalize retaining a losing investment: “I don't really need the money right now, so I won't sell” is a justification that might resolve cognitive dissonance. This type of rationalization often leads to sub-optimal investment results.
Note
1 1 James Montier, Behavioural Finance: Insights into Irrational Minds and Markets (West Sussex, England: John Wiley & Sons, 2002).
4 Belief Perseverance Bias #2: Conservatism Bias
To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight, or inside information. What's needed is a sound intellectual framework for decisions and the ability to keep emotions from corroding that framework.
—Warren Buffett
Bias Description
Bias Name: Conservatism
Bias Type: Cognitive
Subtype: Belief perseverance
General Description
Conservatism bias is a mental process in which people cling to their prior views or forecasts at the expense of acknowledging new information. For example, suppose that an investor receives some bad news regarding a company's earnings and that this news negatively contradicts another earnings estimate issued the previous month. Conservatism bias may cause the investor to underreact to the new information, maintaining impressions derived from the previous estimate rather than acting on the updated information investors persevere in a previously held belief rather than acknowledging new information; this is again a variation on the cognitive dissonance theme described in the last section.
Example of Conservatism Bias
James Montier is author of the book Behavioural Finance: Insights into Irrational Minds and Markets1 and an analyst for DKW in London. Montier has done some exceptional work in the behavioral finance field. Although Montier primarily studied the stock market in general, concentrating on the behavior of securities analysts in particular, the concepts presented here can and will be applied to individual investors later on.
Commenting on conservatism as it relates to the securities markets in general, Montier noted: “The stock market has a tendency to underreact to fundamental information—be it dividend omissions, initiations, or an earnings report. For instance, in the United States, in the 60 days following an earnings announcement, stocks with the biggest positive earnings surprise tend to outperform the market by 2 percent, even after a 4 to 5 percent outperformance in the 60 days prior to the announcement.”
In relating conservatism to securities analysts, Montier wrote:
People tend to cling tenaciously to a view or a forecast. Once a position has been stated, most people find it very hard to move away from that view. When movement does occur, it does so only very slowly. Psychologists call this conservatism bias. The chart below [Figure 4.1] shows conservatism in analysts' forecasts. We have taken a linear time trend out of both the operating earnings numbers and the analysts' forecasts. A cursory glance at the chart reveals that analysts are exceptionally good at telling you what has just happened. They have invested too heavily in their view and hence will only change it when presented with indisputable evidence of its falsehood.2
This is clear evidence of conservatism bias in action. Montier's research documents the behavior of securities analysts, but the trends observed can easily be applied to individual investors, who also forecast securities prices, and will cling to these forecasts even when presented with new information.
Figure 4.1 Montier Observes That Analysts Cling to Their Forecasts
Source: Dresdner Kleinwort Wasserstein, 2012
Implications for Investors
Investors too often give more attention to forecast outcomes than to new data that actually describes emerging outcomes. Investors are sometimes unable to rationally act on updated information regarding their investments because they are “stuck” on prior beliefs. Box 4.1 lists three behaviors stemming from conservatism bias that can cause investment mistakes.
BOX 4.1 Conservatism Bias: Behaviors That Can Cause Investment Mistakes
1 Conservatism bias can cause investors to cling to a view or a forecast, behaving too inflexibly when presented with new information. For example, assume an investor purchases a security based on the knowledge that the company is planning a forthcoming announcement regarding a new product. The company then announces that it has experienced problems bringing the product to market. The investor may cling to the initial, optimistic impression of some imminent, positive development by the company and may fail to take action on the negative announcement.
2 When conservatism-biased investors do react to new information, they often do so too slowly. For example, if an earnings announcement