Cognitive dissonance

Cognitive dissonance is the mental stress we experience when we realize that we are holding two conflicting beliefs at the same time. In finance, the effect  is studied within the field of behavioral finance. On this page, we give a definition of cognitive dissonance, provide some finance examples, and look at the implications for investors.

Cognitive dissonance definition

Cognitive dissonance is the feeling of discomfort when trying to maintain two conflicting beliefs. For example, suppose you believe cheating for a test is wrong. However, during a test you find yourself trying to look at your neighbour his or her answer sheet. Once you realize what you are doing, you will be emotionally affected by this, and start feeling discomfort. That feeling, and trying to rationalize the two beliefs (cheating is bad versus trying to cheat yourself), is cognitive dissonance.

Cognitive dissonance finance

In finance, this type of discomfort has been analysed by behavioral finance economists. To see how the effect can be at play in financial markets, let’s consider some cognitive dissonance in finance examples.

Suppose there is a stock that you want to buy because you believe the company will perform well in the future. The stock currently trades at $60 and you think about buying if the price drops a few dollars, say to $55. The following days the stock drops in price, to $58, and you think it will hit your target of $55 soon. However, suddenly to stock jumps to $65, because other investors start buying it. At this stage, you will probably experience cognitive dissonance.

Why? You will feel discomfort because the sudden jump in the price indicates that the stock was already a good buy at $58. At least, the market suggests that was the case. There’s a high chance you’ll buy some stocks yourself at the price of $65 to assuage the discomfort you feel. You’ll rationalize buying the shares at $65 by thinking it’s still a good deal because, if it’s currently trading at that price, other investors are still willing to buy it at that price.

However, the above behavior is irrational. If the stock is only a good buy at $55, it’s not a good buy at $65. However, by telling yourself that other people are buying it at a higher price to rationalize buying it yourself as well, you’re being irrational. Investors should stick with their decisions, and don’t let emotions determine trades.

Cognitive dissonance occurs all of the time, even at the aggregate level. New information on the state of the economy becomes available and market participants are spooked. That leads to declining stock prices and to a large extent drives market sentiment. Cognitive dissonance and its impact on prices will be larger if news goes against current market participants’ views.

Conclusion

Cognitive dissonance is a behavioral bias that may induce irrational behavioral. In finance, it can lead people to buy and sell impulsively. This should be avoided.

 

FACEBOOK
TWITTER
GOOGLE
http://breakingdownfinance.com/finance-topics/behavioral-finance/cognitive-dissonance">