Cognitive dissonance basically encompasses the response that arises as investors
struggle to harmonize cognition and thereby relieve their mental discomfort.
For example, let's say I'm an investor and
I purchased a stock initially believing that it's the best stock available.
However, when a new cognition that favors a different stock introduced
representing an imbalance, cognitive dissonance then
occurs in me in an attempt to relieve the discomfort with the notion that
perhaps as an investor I did not purchase the best possible stock.
Or I did not invest in the best possible way.
Investors can go to great length to convince themselves that the stock that
they actually purchased is a better trade than the one they just
learned about to avoid mental discomfort associated with the initial trade.
And investors often reform, no far reaching rationalization in order to
kind of synchronize their cognition and
maintain psychological cognitive stability.
When investors modify their trading behavior, or cognition to achieve
cognitive harmony, the modifications that they may make but
if I'm an investor I may make, I may not always
rationally be in my self interest, or the investors self interest in general.
There are two different aspects of cognitive dissonance
that pertains to investment decision making.
The first one is selective perception.
Investors suffering from selective perception tend to only register financial
information that appears to affirm a chosen trait or a chosen investment and
therefore produces a view of liquidity that is incomplete and hence inaccurate.
So in able to objectively understand available data and financial information
and become increasingly, therefore become prone to subsequent miscalculations.
The second aspect of cognitive dissonance is selective decision making.
Selective decision making usually occurs when, let's say I'm an investor,
my commitment to an original trade is extremely high.
So basically selective decision making rationalizes action
that enable an investor like me to adhere
to a particular course even if it comes at an exorbitant cost.
Selective decision makers might, for example,
continue to invest in the stock whose prospects have soared in order to avoid
quote-unquote wasting the balance of a previously sunk fund.
So I've invested something.
I know it's a bad investment, but
I still continue to go on investing in that particular fund.
So some investors like me subjectively reinforce decisions or
commitments they have already made.
And so, if I have committed to a particular stock and
I think that it's a good stock to hold I may actually invest more,
even though the company's prospects do not look very good.
This is because investors, like everyone else,
have their own need to be able to live with their decisions.
A lot of investment professionals go to great lengths to rationalize their
decisions on investments, especially investments that I've lost money.
One of our investors displaying this tendency might also
irrationally delay unloading stocks or investments, or
assets that are not generating adequate returns.
In both cases the effect of cognitive resonance prevents investors from acting
rationally.
And in certain cases, preventing them from cutting down losses and
allocating their portfolios, at the earliest possible opportunity.
Perhaps more importantly, an investors need to maintain his or her self-esteem
and prevent the investor from learning from one's own past mistakes.
To eliminate dissonance arising from the pursuit of what I
may perceive to be incompatible goals, which is basically,
self validation and acknowledgement of past investment mistakes.
As an investor I may often attribute my failures to chance rather than to poor
decision making.
So it's possible that you find a lot of investors justifying that trade and
justifying the losses that they have made and
attributing that to chance than to poor decision making.
Of course, investors who miss opportunities to learn from past
miscalculations are prone to miscalculate again, and thereby, renew a cycle
of anxiety, discomfort, dissonance, and denial from their investments.
We spoke about selective perception and selective decision making.
Both selective perception, which is basically information distortion to meet
a need which gives rise to subsequent decision making errors.
And selective decision making, which is basically a rational drive of an investor
to achieve some specified result for the purpose of indicating a previous or
kind of validating of previous investing decision.
Both of these aspects can have significant effect on investors.
Cognitive dissonance can cause investors to hold losing securities position than
they otherwise would sell because they want to avoid the mental pain associated
with to themselves that they have made a bad investment decision.
A cognitive dissonance can cause investors to continue to invest
in a security that the elderly own after it has gone down to
confirm an earlier decision that they have made to invest in that security
without judging the new investment with objectivity and rationality.
So we don't necessarily judge the new investment objectively and rationally.
A common phrase for this is throwing good money at bank.
Cognitive dissonance can cause investors to get caught up in herd behaviour.
That is investors avoid information that counters
an earlier decision that they have made until so
much counter information is released that investors herd together and
cause a deluge of behavior that is counter to the previous decision.
This normally results in huge selloffs in the stock market.
Cognitive dissonance can cause investors to believe that it is different this time.
And investors who purchased high-flying stocks, hugely overvalued stocks,
way back in the late 1990s and the 2000s, ignored evidence that there was no excess
return to be made from purchasing the most expensive stocks that were available then.
In fact, many of those high-flying stocks were much below their peaks in 2001.
And a lot of investors refused to sell these stocks in 2001 even as
the prices were crashing.
Eventually they did get caught up in the herd behavior where there was so much
confident information that got released that investors herded out together.
And there was a huge sell-off in these Internet stocks and
Internet stocks plummeted.
Well, how to avoid this and become a better investor?
The bottom line in outcoming the negative behavioral aspects of
cognitive dissonance is that investors need to immediately admit
that a faulty cognition has occurred rather than adopting beliefs or
actions in order to circumnavigate a cognitive dissonance.
As an investor, I must address feelings of unease at the source,
and take an appropriate rational action.
If I think that I have made a mistake,
I've made a bad investment decision, I need to analyze the decisions.
And if my fears prove correct, I need to confront the problem head on and
rectify the situation.
In the long run that's how I'll become a better investor.
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