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Belief Perseverance Bias #1: Cognitive Dissonance Bias

This above all: to thine own self be true, And it must follow, as the night the day, Thou canst not then be false to any man.

Polonius to Laertes, in Shakespeare's Hamlet

Bias Description

Bias Name: Cognitive dissonance

Bias Type: Cognitive

Subtype: Belief perseverance

General Description

When newly acquired information conflicts with preexisting understandings, people often experience mental discomfort—a psychological phenomenon known as cognitive dissonance. Cognitions, in psychology, represent attitudes, 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.

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 perceptions of relevant action(s).
  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).
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