Cognitive Dissonance Is Hurting Your Returns

Regular readers know I enjoy discussing behavioral aspects of investing. The reasons for this are twofold: First, we can’t control the markets, but we can control our own reactions to it (at least we can try). And second, many studies have shown that investors suffer from a behavior gap between what they should garner in returns and what they actually get.

Of all of the failings of human wetware, the one I find most intriguing is cognitive dissonance. You can find technical definitions at Changing Minds, The Skeptics Dictionary or any number of other reference books.

In the context of economics and investing, my preferred definition is as follows: 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.

Stated more plainly, when facts conflict with beliefs people find ways to ignore those facts, rationalizing them in a way that allows the disproven ideas to survive. John Kenneth Galbraith famously referenced cognitive dissonance before it was even called that, stating “Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof.”

I was reminded of this recently courtesy of several seemingly disparate but cognitively-related articles. The New York Times discussed the idea in “When Beliefs and Facts Collide”; my colleague Michael Batnick focused on cognitive dissonance and investing in “Climate Change and the Efficient Market Hypothesis.”

Consider the following: Much of what we do is predicated upon a specific abstract belief system. Investors and traders hold and act on a tremendous range of philosophies — from value investing to market timing, stock selection, momentum trading, chart reading, etc. All of these have their positives and negatives, but none of them excel all of the time in all markets. Hence, we are often confronted with data that conflicts with the basic philosophy that we use to govern how we deploy our capital.

The important aspect of this is how we respond to this conflict. We can rationalize the data, or we can accept the facts and make changes to our beliefs.

Examples are many and varied: Deep value investors who buy depressed stocks without regard to other risk factors, only too see them fall another 50 percent; buy-and-hold investors who get demolished in a bear market, only to sell out at the bottom; radical deregulation resulting in bad outcomes rather than the free market nirvana its believers espoused; Austrian economists warning of imminent hyperinflation and the collapse of the fiat dollar that never arrives.

Rather than question the theory, the person suffering from cognitive dissonance ignores the facts in front of their very eyes and instead devises rationales for why any specific expected outcome never occurred. The blame is laid elsewhere, never on their disproven thesis.

Perhaps my favorite example came about after housing-market collapse. It wasn’t the wildly irresponsible behavior of non-bank lenders and junk mortgages securitized and rated AAA that caused the problems. Rather, it had to be something else, and if we can find a government entity to blame, so much the better. Watching the endless attempts to throw something against the barn door to see what might stick would have been amusing if it were not so sad: It was the Community Reinvestment Act! No wait, it was the FHA’s VA loans. No, it was Fannie and Freddie!

The grim reality was much more complex. Many factors deserve blame, ranging from ultra-low interest rates, falling real incomes and a mad scramble for yield. These combined with the deregulation of the past decades created a unique set of circumstances that allowed traditional lending standards to fall by the wayside. You know how all of that ended.

Refusing to acknowledge the complicated reality once it conflicts with your belief system is a classic example of cognitive dissonance. If you can’t face the reality of the housing collapse, cook up some story that explains what happened consistent with your ideology. That it might be very easily debunked is beside the point.

We see this manifested in many ways in investing and trading. There is a fine line between having confidence in your methodologies and living in your own private fantasy world.

Like it or not, this is the human condition. Recognizing it at least gives us a chance to avoid getting caught in its pernicious grasp.

In investing, just because you have human failings doesn’t mean you have to act upon them.

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