Chapter 6

Love is blind (cognitive dissonance)

Have you ever noticed how some people seem to fall in love with a stock and stick with it through thick and thin? How they will maintain that it is a good investment, even in the face of the most convincing evidence to the contrary? Have you wondered why they don’t see that its fortunes have changed and sell it before they lose heavily on it?

Have you ever wondered why so many people bought risky stocks in the bull market leading up to the 2008 global financial crisis, only to lose it all when prices plunged or the companies went bust? Wasn’t the evidence clear that it was a dangerously overvalued market? Why did they buy such heavily indebted and overvalued stocks in the first place and why didn’t they sell before it was too late?

These are examples of people fooling themselves. The explanation of why they fool themselves lies in the theory of cognitive dissonance, developed by Leon Festinger in his 1957 book A Theory of Cognitive Dissonance.

Many people see the actions of investors and traders in the stock market as being driven by either fear or greed. These are very powerful emotional forces, but to understand the stock market only in these terms is too simplistic. Human beings are far more complicated and their motivations far subtler. The idea of cognitive dissonance is not a complete answer either, but it is another step towards developing an understanding of how people behave in stock markets. What is more important, it provides some useful ideas for how we can make better investing decisions.

Classical economics is based on, among other things, the simple assumption that people always behave rationally. However, in the past few decades, many researchers have questioned the reality of this assumption. Indeed, there is a growing body of work based on the idea that people are rationalising beings rather than rational beings. Cognitive dissonance is one such area of study.

One hot summer’s day a Fox was strolling through an orchard till he came to a bunch of Grapes just ripening on a vine which had been trained over a lofty branch. ‘Just the thing to quench my thirst’, . . . Drawing back a few paces, he took a run and a jump, and just missed the bunch. Turning round again with a One, Two, Three, he jumped up, but with no greater success. Again and again he tried after the tempting morsel, but at last had to give it up, and walked away with his nose in the air, saying: ‘I am sure they are sour’.

This fable by Aesop is an example of cognitive dissonance in action. Cognitive dissonance is the discomfort people feel when they either:

• hold two opinions that are in conflict with each other, or

• find themselves acting in ways that are in conflict with their knowledge or opinion.

In the fable, the fox’s action was to give up jumping for the grapes. This was in conflict with his opinion that the grapes were delicious. Festinger’s theory of cognitive dissonance would predict that the fox would then either:

• change his actions (resume jumping for the grapes), or

• change his opinion to justify his actions (the grapes are not delicious after all).

In the fable, the fox changed his opinion, which justified his action in walking away. Most people react in just this way when faced with this kind of situation.

Cognitive dissonance is a type of consistency or balance theory. The basic idea is that the clash within a person between two opposing views or between their opinions and their actions, called dissonance, will make them feel uncomfortable. If this discomfort is strong enough, it will motivate them to try to reduce the dissonance.

While the person suffering dissonance will change their actions in many situations, the theory suggests that there is also a strong tendency for people to change their opinions to bring them into line with, or to justify, what they are doing, or the action they intend to take. This removes the dissonance and is what the fox did in the fable.

The ideas involved in the theory of cognitive dissonance usually apply to situations of uncertainty. The stock market operates in an atmosphere of uncertainty. There is no absolute and objective way of knowing the value of a stock or how its price will change in the future. It is therefore an area in which it is common to see people change their opinions to bring them into line with their actions.

People go about resolving cognitive dissonance in four ways:

• They simply avoid situations, or exposure to information, that they feel will produce the dissonance.

• They actively seek out situations, or new information, that are not in conflict with their actions or one of their opposing opinions.

• They redefine as less important the opinion they hold that is in conflict with their actions or one of their opposing opinions.

• They change one of their opposing opinions or they change their behaviour.

The first two of these strategies fall under the heading of what Festinger called selective exposure. I encountered an extreme example of selective exposure in the stock market some years ago. I had occasion to ask an acquaintance how his stock portfolio was performing. His answer was, ‘I don’t know really. My stocks have been going so badly I have stopped looking up their prices.’

We simply avoid exposing ourselves to information that causes dissonance and we seek out information that confirms our actions or the opinion we favour. This often involves choosing to read only some information, select particular radio or television programs, visit only specific internet sites or associate only with those people who share our favoured opinion or who validate our actions.

Redefining an opinion is what the fox did in the fable. It is also what smokers do when they cannot give up the habit. Confronted by evidence of the dangers, they question the evidence or its relevance to their situation. It is also what failed dieters do. They redefine the importance, or the relevance to them, of the dangers of being overweight.

A fascinating aspect of cognitive dissonance theory that has direct application to investment in stocks is what is called post-decision dissonance. This is popularly called the ‘morning after’ syndrome. The decision to invest in stocks often generates intense emotional tension after the decision is made. This is particularly so if a significant amount of money is involved; we have taken considerable time to choose between two equally attractive stocks; and there is significant cost or difficulty in reversing the decision. Frequently, people will try to reassure themselves by continuing to seek information about the stocks they have bought. They will also seek out people who will assure them that they made the right decision.

If we return now to our investor who falls in love with a stock, we can see that this is quite simply cognitive dissonance theory in action. Our investor buys a stock. For the first year it goes up and up in price. This strongly validates the initial decision. Then it starts to fall in price when some bad news is announced. There is now a conflict between what our investor has done — buy the stock — and the information that is coming through. Then it keeps falling, eventually erasing all the gains of the first year and then some.

A purely rational investor might have sold the stock by this time. However, it is likely that our investor will not sell. Instead, they are likely to interpret the bad news as only temporary or not as important as the market seems to be judging it to be. They may also emphasise the positive aspects of available information and avoid noticing anything negative about the stock. They might also seek out the views of people who they feel are most likely to reassure them that everything is fine.

The same dynamics of cognitive dissonance apply to those who speculated in high-risk stocks during the boom leading up to the global financial crisis in the face of evidence that the market was dangerously high. They tended to talk only with people who had also bought those stocks. They also accepted various theories advanced by brokers, experts and gurus that the market was not really high. Finally, they only sought information from the media that supported their decision, ignoring or downplaying all the warnings and negative news.

Summary

Cognitive dissonance is the discomfort felt when there is conflict between the facts and our opinions or actions. Sometimes this leads to changed behaviour, but there is a strong tendency to redefine our opinions to justify our actions. A common impulse is to seek only confirming evidence and ignore disconfirming information. Avoiding these tendencies to mould our opinions to justify our investment actions is difficult, but being aware of the emotional dynamics behind cognitive dissonance is a first step to realising that we may be in danger of rationalising what we want to do or being blind to the case against it. We need to focus on ways to avoid our tendency to make and hold on to poor decisions by changing our opinions or hiding from the facts to justify our actions or proposed actions.

Strategies

1 A technique that I learned in school for answering exam questions can be invaluable in dealing with cognitive dissonance. Take a sheet of paper and draw a vertical line down the middle. On the left side, we list all the positives about the situation. On the right side, we list all the negatives about the situation. Then we try to form an overall judgement of the importance of the pros and cons. This is very important when we feel that an investment is a near certainty; we must also be able to see why someone would sell the stock to us. If we cannot see the negatives in a situation, we should seek out someone who can help us to fill in the right-hand column. This leads into the second strategy.

2 Historically, when a proposal was made to make someone a saint in the Catholic Church, the Pope would appoint a Devil’s Advocate. The task of the Devil’s Advocate was not to consider the proposal as such, but to present the Pope with all the reasons why the candidate should not be made a saint. We can apply this technique by finding someone who has knowledge of the situation and asking them to argue against our proposed decision. Many people do not understand the true concept of a devil’s advocate, so it pays to explain it at the outset.

3 The previous strategy can be difficult for us because we may be reluctant to expose our thinking to others, or we may not know anyone who has the knowledge to fill that role. In this case, we can imagine we are on a debating team. Suppose that our opponents in the debate are trying to convince us that we should buy the stock we are attracted to (or to continue holding a stock that we own). Our task is to think of all the arguments we might use to refute their proposal. In other words, by putting ourselves in an imaginary situation where we pretend that we have to argue against something we believe or want to do, it is possible to become our own devil’s advocate. In no time we will have completed both columns on our sheet of paper and can start to form a balanced and rational decision.