What is Cognitive Dissonance?
Cognitive dissonance is the unpleasant emotion that results from believing two contradictory things at the same time. The study of cognitive dissonance is one of the most widely followed fields in social psychology. Cognitive dissonance can lead to irrational decision making as a person tries to reconcile their conflicting beliefs.
- Cognitive dissonance occurs when a person believes in two contradictory things at the same time.
- Within investing, it can lead to irrational decision-making.
- Typically the person experiencing cognitive dissonance attempts to resolve the conflicting beliefs so that their thoughts once again become linear and rational.
Understanding Cognitive Dissonance
Conflicting beliefs can be held at the same time, often without a person realizing it. This is particularly true when the conflicting beliefs deal with different areas of life or are applied to separate situations. When a situation causes the person to become conscious of their conflicting beliefs, cognitive dissonance occurs and creates an uneasy feeling. The person experiencing the dissonance will work to resolve one of the conflicting beliefs so their thoughts are once again linear and rational.
According to previous research, sunk costs can lead to and reaffirm cognitive dissonance. This is because an individual or trader's future decision making may be influenced by his previous investment decisions. As such, his future decisions, which may be contrary to his investing beliefs, are taken to reaffirm the amount of time and money he has invested into his previous ones.
Example of Cognitive Dissonance
For example, an investor believes heavily in the "sell in May and go away" market anomaly. The investor thinks that people sell stocks in May and it causes prices to be artificially depressed. Therefore, you shouldn't ever sell stocks in May because the selling bids down prices and you can't ever get the best price.
Separate from this thought, the investor receives a call from his broker about a stock he owns. Apparently, the company is going through a hostile takeover and the stock price has started to fall. The broker thinks this is only the tip of the iceberg and that the investor should immediately sell the stock. The investor is on board until they look up at their calendar and see it is May 1. The investor immediately thinks of the "no selling in May" guideline and starts to experience anxiety related to cognitive dissonance. The investor will have to find a way to reconcile their desire to sell the stock with the belief that selling stocks in May is a bad idea to be at peace with whatever decision they reach.