Cognitive Dissonance

"The four most dangerous words in investing are, it’s different this time." — Sir John Templeton

As we wrapped up 2020, there were investment decisions that came to the forefront. I am specifically referring to tax loss selling. In our portfolio we certainly had positions that did not perform as well as expected and we did have losses in these positions. With the market hitting all-time highs, it makes complete sense to harvest the losses from these positions and reallocate to other investments that perhaps offered better profit opportunities. This is quite easy to write about, but when faced with the actual decision to do so – it wasn’t so easy. With this decision, we were faced with cognitive dissonance.

Leon Festinger (1957) first introduced the concept of cognitive dissonance. Cognitive dissonance refers to a condition in which attitudes, beliefs or behaviors are in conflict. This ensuing conflict produces mental discomfort, or dissonance that leads to an individual attempting to remedy the discomfort through various means, usually leading to an alteration in one of the attitudes, beliefs, or behaviors. Mentin and Camgoz (2001) note that individuals strive toward consistency, so inconsistency that arises from cognitive dissonance produces self-rationalization to restore mental balance. Festinger used the word consonance to depict that consistency. Quite often, this process of restoration through rationalization, in the face of bounded rationality will cause bad behavior leading to sub-optimal decision-making (Tversky, 1990).

When Festinger first introduced the concept in classic 1957 book, A theory of cognitive dissonance, it opened a new field of research that challenged the commonly accepted reinforcement theory, that postulated a combination of rewards and/or punishment could be used to reinforce desired, or deter unwanted behavior (Mentin & Camgoz, 2001). Festinger noted a positive correlation between the importance of one’s held attitudes, beliefs, or behaviors and the magnitude of dissonance that occurs when one’s action in in violation to those attitudes, beliefs, or behaviors.

To illustrate cognitive dissonance, Festinger (1957) provided the oft cited example of the cigarette smoker. The cigarette smoker understands that smoking cigarettes is unhealthy and may lead to lung cancer yet continues to smoke. This conflict between belief and behavior will cause cognitive dissonance. He notes the three possible ways to eliminate the cognitive dissonance is to (1) change the action (to quit smoking), (2) change the belief (smoking is not unhealthy and dangerous), or (3) change the perception of the action (there is greater danger in traffic). One’s rationalization towards one’s decision to keep smoking is a prime example of poor decision-making due to the desire to eliminate cognitive dissonance. Changing one’s belief to self-rationalize, i.e. I smoke light cigarettes or lung cancer does not run in my family genes are methods to cope with inherently bad decisions.

Portfolio Decision

What we witnessed when making our decision to harvest the losses from underperforming investments was mental discomfort. This discomfort arose from the belief that our original investment thesis regarding the investment was strong, yet selling the position for a loss would be an admission that our analysis was flawed. This cognitive dissonance that we experienced enticed us to seek resolution. Our option to do so where as follows. We could first admit to the flawed analysis and sell the position for a loss, harvesting the loss, and pressing forward to find new opportunities (change the action). We also had the option to disregard the facts. We could have convinced ourselves that the negative fundamental changes for the company were temporary, the balance sheet wasn’t as bad as it appeared, or management really did a great job and “the market” got it wrong (change the belief). Finally, we could have self-rationalized our reasons for not selling the position (change the perception). Such excuses as, “with the dividend we are getting paid to wait”, “I’m holding it for nostalgic reasons”, or “I don’t really need these losses this year”.

In the end, the decision was a hybrid between option one and three, selling some but justifying holding the rest. Probably not the optimal solution. Understanding how cognitive dissonance affects our decisions for the purposes of selling underperforming investments, it begs to research how this particular behavioral bias affects other aspects of the investment decision-making process.

Cognitive Dissonance in Finance

In the field of finance and investing, cognitive dissonance can cause anxiety or euphoria, the adage of fear and greed applies appropriately. One may feel dissonance from cognitive conflict by believing one is a good investor or trader yet have sub-optimal returns. This in turn alters the underlying attitudes, beliefs, and behaviors to mitigate dissonance. As opposed to analyzing and possibly changing one’s investment style in search of greater returns, the investor may refuse to accurately track and record performance. This is a fear of having one’s underlying attitudes, beliefs, or behavior shown to be proven wrong. During the market crash of 2008-09, there were many individuals that chose not to even open their monthly statements for fear of discovering that perhaps their judgement and decisions about the investment type or investment manager were proven to be sub-optimal.

Cognitive dissonance will tend to cause individuals to overweight the relevance of news or information that favors their decision and discount news or information that goes against their decision, thus leading to confirmation biases (Baker & Nofsinger, 2010). This very same dissonance effect may cause investors to overestimate their portfolio or trading returns and remember only the positive experiences of administering a specific investment strategy (Baker & Nofsinger, 2010). Sufferers of cognitive dissonance will have a difficult time learning from past mistakes and will be slow to alter or change a strategy that is sub-optimal.

Another example of how cognitive dissonance can negatively impact market returns is through what Barberis and Xiong (2009) deemed the disposition effect. Selling a stock for a loss is an unpleasant experience for investors, even though the use of stop losses is imperative to many stocks trading strategies, especially knowing that the best trading strategies entail suffering many small losses in search for the new trend and letting that winner ride. Dissonance in this instance will compel investors to sell winning stocks for small gains while holding deteriorating investments for large losses (Chandra, 2009).

Cognitive dissonance and locus of control tend to exhibit cross-relational patterns. Lather et al., (2020) used locus of control studies to identify how individuals perceive their environment and the ultimate causes of their success in life. Individuals with internal locus of control believe that the successes in their lives were primarily a result of their own behaviors and actions. Individuals with external locus of control believe their successes are a result of the power of others or by pure chance. The subscale of internal locus of control is called individual control while the two subscales under external locus of control are called powerful others and chance. What the researchers discovered is that investors that exhibit low internal locus of control are most susceptible to cognitive dissonance. Additionally, they found investors with low chance control are most likely to exhibit cognitive dissonance traits.

Sharma (2014) notes the greatest pitfalls related to cognitive dissonance include, (1) the likelihood of ignoring relevant new information (underreaction), (2) overconfidence in one’s decision-making ability, and (3) biased interpretation of newsworthy information (overreaction). Additionally, Pompian (2012) goes on to list the major mistakes that investors and traders make when subjected to the dissonance effect. The first major mistake caused by the dissonance effect is when investors hold losing positions that should otherwise be sold. The mental discomfort of admitting an error in analysis through the sale of a security for a loss is too great. The investor will rationalize the reasons for owning the position. Dollar cost averaging is another way of coping with cognitive dissonance. Doubling down on a position that should otherwise be sold is described as “throwing good money after bad.” This idea is further advanced through the research of Chung and Cheng (2018) that draws attention to the influence cognitive dissonance can have on the sunk cost effect. Sunk costs are costs that have occurred in the past and should logically be irrelevant towards future investment decisions. They found that investment decisions can be impacted by cognitive dissonance leading investors to continue to invest in opportunities that should otherwise be abandoned.

Pompian (2012) notes that cognitive dissonance can also produce herd behavior. This will occur when investors avoid information that runs counter of their internal attitudes, beliefs, or behaviors until so much counter information is released that investors herd mentality cause a pattern of behaviors that run counter to the decision. Lastly, investors attempt to self-justify their actions. The opening of this essay starts with a quote from Sir John Templeton, famed manager of the Templeton Growth Fund. When investors express the view that “this time it’s different”, it usually is not. When gripped by the notion that the situation is different, it is usually a defense mechanism to combat the mental discomfort caused by cognitive dissonance.

Empirical Studies of Cognitive Dissonance and Behavioral Finance

There have been many interesting scientific experimentations regarding the link between cognitive dissonance and the financial markets. One widely quoted example is the study from Goetzmann and Peles (1997) regarding mutual fund investors and their recollections of past fund performance. Cognitive dissonance has been shown to alter one’s beliefs about investing performance as a coping mechanism to stymie the mental discomfort of realizing an investment was a poor decision. Goetzmann and Peles (1997) provide examples of the theory by examining an unusually high frequency of poorly performing mutual funds. This is partially due to an investors inability to realize an investment mistake and a reluctance to liquidate poorly performing mutual funds.

Drees and Eckwert (2006) discovered that investors have rational expectations on performance ex ante, but once the decision to invest is made, the utility-maximizing beliefs often change, and important unfavorable information is discounted. This can be found in distorted asset prices. They postulate that the more extreme (negative or positive) the information that is ignored, the greater the mispricing becomes. This type of behavior can lead to overconfidence and underreaction as it relates to new information.

Findings from Doukas et al., (2009) discussed whether overall market sentiment affects the profitability of price momentum strategies. They went on to hypothesize that news that contradicts investors’ sentiment caused cognitive dissonance to discount information that ran counter to existing market-based beliefs. On an aggregate level, they found that during times of overall market optimism, negative news will be discounted and further surmised that momentum-based strategies produce the largest profits when market optimism is highest. They concluded by showing that smaller (and presumably less sophisticated) investors are reluctant to sell losing stocks during optimistic market periods.

Pirie and Chan (2018) analyzed momentum strategies in Asian markets. They discovered subpar results were realized when compared to momentum strategies in other parts of the world. In light of this information, they found that investors continuously adopt momentum strategies in Asian markets despite the relative underperformance. They noted in part that the reason for such behavior may stem from performance pressures and the influence of cognitive dissonance.

In another fascinating study, Moszoro (2020) found a link between political cognitive biases and fund manager performance during the Great Recession of 2008-09. The research discovered that there were significantly higher portfolio returns for Democratic hedge fund managers during this period than for Republican hedge fund managers. The author argues that it is likely that the divergence between the fund performance of differing political views is a result of each parties’ interpretation and expectation of central bank policy and the ability of the incoming Obama administration. The dichotomy of political views brought about cognitive dissonance.

The consequences of poor decision-making stemming from cognitive dissonance will lead to other behavioral bases. Festinger (1957) found that individuals, post decision will tend to rationalize their decision as the best decision even if evidence suggests otherwise. This process of rationalizing the decision, to frame the decision in the most positive light while discounting the attractiveness of the alternative decision may lead to various behavioral biases such as confirmation bias, conservatism bias, illusion of control, self-attribution bias, recency bias, disposition effect, overconfidence bias, and affinity bias.

Further Research

The theory of cognitive dissonance has been considered a bit controversial throughout its existence and has brough to the surface many new ideas on how cognitive dissonance occurs. One such revision was established by Aronson (1968) with the focus of cognitive dissonance stemming from the concept of self or self-consistency. He pointed out that dissonance theory does not rest upon the assumption of the rational individual but rather the rationalizing individual (Aronson 1968). He noted the deficit of the original theory was in the difficulty involved with defining the limits of the theory (Aronson, 1968). He noted that the theory, beyond its central tenets and out to its fringe is not always clear on whether precise predictions can be made to generate a hypothesis.

Additionally, his work assisted in explaining that, although the inconsistencies produced by dissonance can be logical at times, it can also be psychological (Aronson 1968). Dissonance can produce logical inconsistencies, such as a person that understands all people are mortal but believes they will live forever (Aronson, 1968). Dissonance can also produce inconsistencies with cultural mores, i.e., exhibiting behavior that is culturally wrong. Inconsistency from dissonance can arise between one cognition and a more general, more encompassing cognition. Aronson (1968) uses an example of voting in an election. If a person considers themselves a Democrat but votes for the Republican, this is a contradiction of two cognitions that will cause dissonance. Dissonance will occur based on past experience. Aronson (1968) noted that if a person stepped barefoot on a tack and felt no pain, dissonance would occur because of previous knowledge that stepping barefoot on a tack produces pain.

Aronson’s (1968) work revolved around attempting a purification of the theory and noted that dissonance would occur when a person performs a behavior that is inconsistent with their sense of self. To reduce dissonance, the individual would need to go through a process of self-justification (Metin & Camgoz, 2011). It was through this focus on the self, that Aronson attempted to improve the predictive nature of cognitive dissonance.

Further work by Cooper and Fazio (1984) introduced the concept that cognitive inconsistency was not a necessary variable for dissonance to occur. Their research produced the theory that, for individual’s, dissonance will occur when they engage in behavior that has the perceived potential to cause an unwanted consequence. An individual’s sense of self-responsibility will cause dissonance when a decision is made that is perceived by the individual to lead to aversive consequences (Cooper & Fazio, 1984).

Further Research of Dissonance Research

It is wise to note the many differing theories that have spawn from the original theory of cognitive dissonance to better explain the process and conditions of cognitive dissonance. Steele (1988) introduced self-affirmation theory. The theory attempts to explain how individuals adapt to information or experiences that are considered a threat to that individuals self-concept. Steele (1988) explains that if individuals reflect on values that they consider personally relevant, they will experience less dissonance when faced with opposing threats to their sense of self. The theory has been suggested as a coping mechanism for individuals experiencing distress. Wicklund & Gollwitzer (1981) introduced the symbolic self-completion theory. Symbolic self-completion theory is the notion that individuals seek to acquire and display symbols that reinforce their ideal self or self-perception. This theory has taken a large role in today’s marketing and advertising behavior towards the consumer.

Tesser (1982) developed what is referred as self-evaluation maintenance theory. This theory touches on the discrepancies between two people in a relationship aiming to keep themselves feeling psychologically euphoric through a comparison process to their partner. Tesser (1982) made the claim that people will try to maintain or increase their self-evaluation which is heavily influenced by one’s relationship with others. Higgins (1989) produced the self-discrepancy theory. Higgins (1989) stated that individuals compare their “actual” self to internalized standards. This is defined as the “ideal self” and inconsistencies between ideal and actual selves will bring about cognitive dissonance. Swann and Read (1981) spoke about self-verification theory. Self-verification theory assumes that individuals want to be perceived by others according to their beliefs and feelings about themselves. The motivation of matching self-view and others perception of one’s self is a method of seeking consistency and perceptions contrary to self-view will be a cause for cognitive dissonance.

Wegner and Vallacher, (1986) introduced action identification theory. This theory specifies the principles where individuals embrace a single act identity for their behavior and outlines the conditions under which individuals maintain this act identity or adopt a new one (Action Identification Theory, 2016). The theory has been shown to have had a profound impact when applied towards concepts in social psychology. Kunda (1987) introduced the concept of motivated inference. Results from the study revealed that individuals will generate and evaluate casual theories in a self-serving manner. Individuals will generate theories within the decision-making process that are in line their own attributes, believing such decisions are more predictive of desirable outcomes. Additionally, individuals are reluctant to believe in theories relating their own attributes to undesirable outcomes. Lastly Harmon-Jones (2002) introduced an action-based model that acts as an extension of the original model and asks why cognitive inconsistency can cause both dissonance and attempts at dissonance reduction. The model assumes individual cognitions impel one to act in a specific manner. They further note that dissonance is not driven by cognitive conflict, but rather cognitions with action implications conflict with each other, thus making it difficult for the individual to achieve balance.

Overcoming Cognitive Dissonance

Taking losses (and profits for that matter) in individual positions is much easier when you take a total portfolio return approach. Focus on the total value of the portfolio as a whole as opposed to the sum of the parts.

I like to think about Sabermetrics when it comes to running the portfolio (A Guide to Sabermetric Research, n.d.). If anyone has seen the movie Moneyball, then you would have a general understanding of the concept. According to the definition by Stamford University (The Truth about Sabermetrics, n.d.),

The formal definition of sabermetrics is the use of statistical analysis to analyze baseball records and make determinations about player performance. Bill James, the founder of sabermetrics, defines the term as, “the search for objective knowledge about baseball.” Baseball is a game of statistics and each one of those statistics means something different. Sabermetricians believe some of those statistics are either overvalued or undervalued. For example, sabermetricians believe that RBIs (Runs Batted In) is a meaningless statistic. In order for a player to have a lot of RBIs, he must consistently have runners on base when he is up to bat. It is impossible for the hitter to control how many people are on base when he is up to bat. Therefore, RBIs do not accurately represent his value as a hitter. Sabermetricians are always looking at data and asking questions about how to apply that data to find the best players for their team. One of the most famous sabermetricians is Billy Beane. Beane is the general manager of the Oakland A’s and is well known for using data to exploit undervalued skills to create a playoff caliber team.

When constructing a portfolio, I look for investments that fit my criteria of outperformance relative to a benchmark and “build my team”. The success of the portfolio (team) will be determined on how well the investments (players) work together in generating satisfactory returns (wins). By focusing on the ultimate objective of risk adjusted portfolio returns (wins) it will be clear if the portfolio is not achieving its stated objective. If that is the case, there needs to be rotations in place to buy and sell (sign and release) certain investments (players) to meet that goal.

Using this baseball analogy works well for me. It keeps me focused on the total portfolio objectives and helps put into perspective that not all investments will be successful, making it easier for me to make the necessary rotation.

Joseph S. Kalinowski, CFA

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