Cognitive Dissonance

Cognitive dissonance refers to a situation involving conflicting attitudes, beliefs or behaviors. This produces a feeling of discomfort leading to an alteration in one of the attitudes, beliefs or behaviors to reduce the discomfort and restore balance, etc.

For example, when people smoke (behavior) and they know that smoking causes cancer (cognition).

According to Michael M. Pompian, author of Behavioral Finance and Wealth Management, Investors with this bias can make investment mistakes such as:

1. Hold on to 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. 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. Getting 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. 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.

Pompian goes on to say that, “The bottom line in overcoming the negative behavioral effects of cognitive dissonance is that investors need to immediately admit that a faulty cognition has occurred. Rather than adapting beliefs or actions in order to circumnavigate cognitive dissonance, investors must address feelings of unease at their source and take an appropriate rational action.”