All investors have pre-existing beliefs about the way investment markets work. These beliefs are often deep-rooted and subconscious.
For example, some investors believe that investing in index funds is better than investing in mutual funds. There are still other investors who believe that investing in precious metals or real estate is better than investing in paper assets.
Most of the time, the information that we receive from the marketplace also confirms our worldview. However, problems start arising when this is not the case.
If the feedback provided by the market conflicts with the beliefs, then the investor experiences some mental discomfort. This mental discomfort ends up disrupting investor behavior. In this article, we will have a look at this bias as well as how it can be avoided.
What is Cognitive Dissonance Bias?
The term cognitive dissonance is made up of two words, i.e., cognitive, which means relating to the brain, and dissonance, which means turmoil or discomfort. Hence, cognitive dissonance bias is related to the mental discomfort which investors have to go through if they have to hold two conflicting views about the market in their minds.
An example of cognitive dissonance bias is when an investor purchases the stock believing that it will give a 15% per annum return. However, over a period of three years, that does not happen. Instead, other stocks provide the 15% per annum return. In this situation, investors face mental discomfort. On the one hand, he/she may believe in the stock that they initially purchased in whereas, on the other hand, he/she may want to liquidate the stock and buy the other one in order to achieve their immediate investment goals.
Investors often go to great lengths to convince themselves that their initial decision was right. They do so because they are predisposed to maintaining their old beliefs.
A lot of times, the cognitive dissonance becomes difficult to manage, and hence investors take hasty decisions. These decisions may not be rational or even in their best interest. They are simply taken to achieve cognitive stability.
Aspects of Cognitive Dissonance
Cognitive dissonance bias manifests itself in the form of two different aspects. The details of these two aspects have been mentioned below:
Selective Perception: Investors who suffer from selective perception are unable to look at the data available in an unbiased format. Instead, they tend to look only at data that affirms what they already believe. The omission of a lot of important data may happen because of this characteristic. The end result is that there may be a huge miscalculation from the investor’s point of view.
Selective Decision Making: Selective decision making is the tendency of investors to stick to a decision previously made. Even if contradictory information appears in the market, the investor seeks to rationalize their behavior instead of correcting the course of their action.
How Cognitive Dissonance Bias Affects Investor Behavior?
Cognitive dissonance bias tends to affect investor behavior in the following manner:
An important part of investing is to learn from one’s mistakes. This is important so that the mistakes are not repeated in the future. However, investors who suffer from cognitive dissonance bias are unable to see their actions and the subsequent results clearly.
Hence, they are unable to accept bad results and take corrective actions. Hence, such investors firstly do not accept that they have made bad decisions.
Even if they do accept, they are likely to attribute the mistake to chance rather than to poor decision making on their behalf. These investors are often caught in an emotional cycle of anxiety, discomfort, dissonance, and then denial.
Investors with cognitive dissonance are also prone to herd mentality. This is because when small snippets of contradictory information are first released, these investors do not pay attention to this information. This is where the selective perception aspect comes into play. However, because of neglect, it is possible that a lot of relevant information has been ignored. Hence, by the time investors decide to act on decision making, there is a stampede in the market place. Because emotions are running so high, people with cognitive dissonance bias are bound to make mistakes.
How to Manage Cognitive Dissonance Bias?
The best way to avoid cognitive dissonance bias is to ensure that users do not get overly emotionally attached to their investment philosophies. They need to realize that markets change, and along with them, investment philosophies also change. None of these philosophies are actually set in stone. Hence, if a mistake has been made, the best course of action is to admit it to oneself and move forward with the corrective action. This will help limit the loss to a minimum.
The fact of the matter is that cognitive bias is not a bad thing within itself. It simply helps us identify a problem and then propels us into action. The manner in which we deal with the situation is important. If the situation is not dealt with rationally, only then does cognitive dissonance change into cognitive dissonance bias.
