How Cognitive Dissonance Thwarts Investment Decision-Making

This is the 14th article in the Behavioral Finance and Macroeconomics series exploring the effect behavior has on markets and the economy as a whole and how advisors who understand this relationship can work more effectively with their clients.

When presented with information that conflicts with pre-existing beliefs, people often experience mental discomfort--a psychological phenomenon known as cognitive dissonance. Cognitive dissonance is a belief perseverance bias, because humans tend to stick with ideas they already believe to be true. This is a very common and very human characteristic, and this concept is ever-present in the world of investment decision-making.

We'll start with a simple example of this bias, and then move to how it can affect decision-making in the investment realm.

Suppose a consumer purchases a certain brand of mobile phone, initially believing that it is the best available. However, when a new cognition that favors a different mobile phone is introduced--representing an imbalance--cognitive dissonance occurs in an attempt to relieve the discomfort that comes with the notion that perhaps the buyer did not purchase the right phone.

Specifically, imagine Jack buys phone X because it has the exact specifications that he wants. He is happy with his purchase. Meanwhile, his friend Sally buys phone Y. She likes her phone and, without trying to persuade Jack in any way, proceeds to compare her phone's features to the features on Jack's phone. Jack suddenly experiences buyer's remorse, but nevertheless decides to argue with Sally that phone X is still better than phone Y. Why? Because Jack wants to convince himself that he made the right decision. This is common: We pursue the belief that we are correct, when, in fact, we may not be.

When it comes to investing, cognitive dissonance can cause investors to fail to recognize information that could help them make a good investment decision because they don't want to admit that they made a poor decision in the first place. At times, an investor's need to maintain self-esteem may prevent him or her from learning from mistakes. To ameliorate the dissonance arising from the pursuit of what they perceive to be two incompatible goals--self-validation and acknowledgment of past mistakes--investors will often attribute their failures to chance rather than to poor decision-making on their part. However, people who miss opportunities to learn from past miscalculations are likely to miscalculate again, renewing a cycle of anxiety, discomfort, dissonance, and denial. At a macro level, this behavior can affect thousands or even millions of investors and can drive market volatility.

Consider the following example of cognitive dissonance in action.

Suppose your client, Keith, is nervous that the markets are too high and are going to fall in the near future. You ask him why he thinks that, and he says he thinks China's economy is slowing down based on numerous articles he has read in major newspapers; as such, he thinks a correction is imminent across global equities. You counsel him that it's important not to let news articles influence his long-term investment plan. Despite your counsel, Keith decides to cut half of his equity exposure anyway. The next day, markets drop 2% as more news comes out speculating about China's woes. Keith feels good. However, a week later a report comes out that the global economy is stronger than expected, and markets rally. You suggest that Keith add back the equity he sold to the portfolio, in an effort to get him back on track with his long-term plan. Keith is now challenged, because he realizes he made a mistake but he has trouble acknowledging this fact.

The driving force behind most of the irrational behavior discussed here is the tendency of individuals to adopt certain detrimental responses to cognitive dissonance in an effort to alleviate their mental discomfort. Therefore, the first step in overcoming the negative effects of cognitive dissonance is to recognize and attempt to abandon such counterproductive coping techniques. People who can recognize this behavior in themselves become much better investors.

I have a three-step process for getting clients to acknowledge a belief perseverance bias such as cognitive dissonance:

1. Acknowledge that you as the advisor have a disciplined process in managing investment decisions.
2. Use facts to explain a more rational alternative to the decision that the client has made. Don't make it personal (they made a bad decision).
3. Reinforce learning through a conversation about the mistake.

Here's how that process would work with Keith:

• "Keith, as you know, we have an investment policy statement that guides our investment decisions."
• "Sometimes, we try to second guess the markets, and we make changes to the portfolio that run contrary to our investment discipline."
• "The good news is that we can learn from this situation. Why don't we rebalance back to our stated policy over the next few quarters, in case the market experiences more volatility? We can take advantage of price drops along the way to build the equity position back up."

Michael M. Pompian, CFA, CAIA, CFP, is the founder and chief investment officer of Sunpointe Investments, an investment advisor to family offices based in St. Louis, Missouri. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients. Contact Michael at michael@sunpointeinvestments.com.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.