Vocabulary Problem: Cognitive Dissonance

Paul Krugman asks:

Unusually, I’m having a vocabulary problem. There has to be some word for the kind of person who considers his mild discomfort the equivalent of torture, crippling injury, or death for other people. But I can’t think of it. What brings this to mind is this from Alberto Gonzales: I consider myself a casualty, one of the many casualties of the war on terror.

The answer to this query is one of my favorite phrases, pulled from psychiatry and often applied to investing. But its just as valid in the legal and political realm.

I typically use it to describe absurd and perplexing statements made sincerely.

The phrase is Cognitive Dissonance.

You can find technical definitions at Changing Minds, Wikipedia, and The Skeptics Dictionary. The way I use it somewhat modifies the classic definition, when applied to an economic or investing context (but it works just as well for politics).

Cognitive Dissonance occurs in the mind of an individual when a theoretical belief system is confronted by factual evidence demonstrating outcomes contrary to what theories dictate should occur.

Examples are many and varied: Deep value investors buying beaten up stocks with no regard to other risk factors, only too see them fall another 50%. Buy & Hold investors getting utterly demolished this year; Radical deregulation resulting in market mayhem being denied by its advocates as a root cause, especially with derivatives. Rather than question the theory — be they Investing or Economic — the person suffering from Cognitive Dissonance ignores the facts in front of their eyes or devises rationales for why the undesired outcome occurred, blaming other factors (but not their thesis).

A few recent classic examples:

• Blaming the housing boom and bust on the Community Reinvestment Act of 1977 rather than an abdication of lending standards (See various posts);

• Phil Gramm denying deregulation had anything to do with the current crisis; (See A DeRegulator Unswayed)

• Blaming the population for being too gloomy (June 08), rather than questioning whether the low unemployment and inflation data where problematic (Are We Too Gloomy?)

• Amity Schlaes false definition of recession to maker the claim there was no economic contraction; (See Amity Shlaes Does Not Know What a Recession Is)

There’s more but you get the idea.

Cognitive Dissonance can lead to a politician appearing out of touch; recall John McCain’s The Fundamental’s of the Economy are Strong quote, which certainly did not help his campaign.

In investing, it can be downright deadly. Those who bought the Home Builders in 2005 had to ignore rising rates AND prices, inventory build and stagnant income. The purchasers of Banks in 2007 or Brokers in 2008 engaged in a similar risk denying approach.

There are many other forms of Cognitive Dissonance in investing and economics, it is one of those psychological factors that astute investors and traders must constantly be on the look out for. Those who are brutally honest with themselves and engage in a degree of introspection should be able to avoid its most pernicious effects.

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Related:
The Psychology Behind Common Investor Mistakes (July 2005)
http://www.ritholtz.com/blog/2005/07/the-psychology-behind-common-investor-mistakes/

Recessions Often Begin With Positive GDP Data (May 2008)
http://www.ritholtz.com/blog/2008/05/recessions-often-begin-with-positive-gdp-data/

Who is Right: Professionals or the Populace ? (June 2008)
http://www.ritholtz.com/blog/2008/06/who-is-right-professionals-or-the-populace/

Pervasive Pollyannas of Prosperity (June 2008)
http://www.ritholtz.com/blog/2008/07/pervasive-pollyannas-of-prosperity/