Cognitive Dissonance Definition
Cognitive Dissonance is nothing but mental stress when a person holds two or more conflicting beliefs at the same time. In simple terms, newly acquired information conflicts with preexisting understanding, in that case, people experiences a mental discomfort which is noticed as a Cognitive Dissonance. In financial terms, cognitive dissonance is measured by behavioral finance.
Below examples helps us to understand how cognitive dissonance effect play in the financial market and how it impacts the individual
Top 4 Examples of Cognitive Dissonance in Everyday Life
Consider a John is looking to buy a stock of an XYZ limited because he believes that XYZ limited will perform well in the future. XYZ limited stock is currently trading in the market at $70 and John is thinking to buy a stock if it falls few dollars to $65. In three days stock price hit to $68 and John thinks the stock price will come to $65 sooner. However, after three days suddenly Stock Price increased, and it reached to $75 because of buying demand from other investors. At this point in time, John will probably experience cognitive dissonance.
Now the question arises why John will experience cognitive dissonance so will try to find out the answer to this.
Here John will feel discomfort because the sudden increase in the stock price of XYZ limited shows that stock was good to buy at the price of $68 and this was suggested by the market as compared to the previous trading price. There are high chances that John will buy some of the stock at the price of $75 to relive the discomfort he feels. John may think that buying a stock at a higher price is still good because other investors are also buying at the same price, but by telling this rationalizes buying John is being irrational.
The above example tells him that investors should stick with their decision and trade should not be determined with emotion.
One of the investors thinks that the current market is at a too high position, and it may fall in near future and as the market is at too high position investor is worried about it and he is planning to sell out some of the equity holdings. The investment manager of investors asked investors that why he thinks that the market will fall in near future, and he says that the global economy is slowing down as published in several newspapers, and corrections will happen in the market because of this. Then investment manager advice investor that does not influence through numerous news articles.
Even after Investment Manager advised investors sold out his 50% equity and next day market tumble by 5%. As market drop by 5% investor feels good and he thought that he made a right decision, but after week news come out that global economy is improving and the market started showing rally and now investment manager suggest investor to add back sold equity into the portfolio to get investor long-term investment plan on track.
So the above example shows that investors influence thorough news articles and he took sold out decisions without checking facts and figures and make a mistake. It shows that cognitive dissonance can cause the investor to fail to recognize the information which helps him to make a good investment decision.
Keith bought a stock of Opto circuits at a trading price of $125. Next week, the stock price of a company fell down and upon analysis, Keith came to know that their aggressive inorganic growth has filled their balance sheet with debt. By this time stock was trading at $75 and Keith bought some more stock again. Keith’s understanding was that company made good quality products and he read the report that once the economic condition improves and interest rates come down, company stock will perform well and due to this Keith was buying at every fall in stock price. During this period Keith was looking for some good news about the company and he used good news about the company to support buying into the stock at every fall.
Keith still on the hope that the company’s position will improve and he will get the stock price of $125 at least.
So above example explain to us that investor who bought the stock in spite it was falling heavily and sitting in huge losses and investor looks for positive news and information about the company just to support his buying decision and to hold on investment to sell it at profit in the future.
During the stock market rally or boom during the year 2005-07, one of the investors in India was investing in companies of capital goods, infra, and power sector, and fortunately that time those stocks were rallying sky high. The investor was really confident that he was having enough skills and expertise in picking stocks because whatever he picked, went up almost daily. He was also entered into a few hot IPO’s.
Then when the global economy was facing recession during the year 2008, the investor portfolio suffered badly and he sold off his entire portfolio at a loss.
The above example shows that in investing, overconfidence investors and traders believe that they are better than everyone else in choosing the best stocks and funds and even better time to enter and exit the position. They are under the belief that they were better and wiser than others in choosing an investment.
So the above examples explain to us how cognitive dissonance influence the investment decision in financial markets. Cognitive dissonance is a varied case to case basis and it is applicable to many situations. In cognitive dissonance, most people are motivated to justify their own actions, beliefs, and feelings, and they used self-perception when dealing with any situation and which is seen in the above examples too. The best way to avoid cognitive dissonance is to be objective and analytical while making investment decisions rather than emotional.
This has been a guide to Cognitive Dissonance and its definition. Here we discuss the top 4 examples of cognitive dissonance in Investing along with detailed explanations. You can learn more about accounting from the following articles –