Cognitive dissonance bias. When new information conflicts with the prior investment decision, smart investor acknowledges it. Do you?

Cognitive dissonance bias among investors is the discomfort of holding two conflicting beliefs, leading to inventing apparently logical explanations for keeping underperforming assets in a portfolio, increasing investment risks. Discover whether you are prone to cognitive dissonance bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.

Behavioural economics. What is cognitive dissonance bias?

Cognitive dissonance is a widespread behavioural pattern among investors and refers to the discomfort resulting from holding two different beliefs. When new information conflicts with one’s existing knowledge or prior investment decisions, one might refuse to update the latter to avoid this mental discomfort.

Cognitive dissonance is a cognitive bias, i.e., a mistake in decision-making. These biases can be effectively corrected with education.

What are the consequences and investment risks?

One may come up with a series of apparently logical explanations for why keeping an underperforming asset in one’s portfolio is okay. These may include “the price fall is temporary, “the financials of the company will improve soon”, “this time it is different”, or “many other investors want to buy this asset, so its price will go up soon”. Or one may continue investing in an asset after it has gone down without refreshing the risk analysis of the asset.

What can I do to make my portfolio more efficient?

The first step is to recognise cognitive dissonance in investment decision-making or risk management strategies. Try to recall when you refused to change an earlier decision, only to discover that it was incorrect or that you could have done better. It does not matter whether it was a big decision like buying a house, or a minor one like picking a stock to invest. The more you recall, the more likely it is that you are prone to cognitive dissonance behavioural finance bias.

The next step is avoiding several common mistakes in correcting cognitive dissonance bias. The first mistake is changing your core beliefs rather than your actions. You can convince yourself that holding a fallen stock expected to drop further is a good idea. This path of least resistance will help temporarily alleviate the bias but will not correct the initial asset allocation mistake. The decision to sell a collapsed stock is still there to be made to diminish portfolio risk. The second error is admitting the mistake and promising not to repeat it. The promise of future action alleviates the dissonance today but does not correct the primary cause. A third typical incorrect response is changing the context of an action. With the fallen stock example, you may come up with explanations along the lines of “I do not see other better investment opportunities at the moment, so there is no point in selling now”, or “All stocks are expected to fall further in this market meltdown, so there is no point in selling this particular one”. Such reasoning changes the context but does not correct the mistake itself. The only correct decision when holding a fallen stock expected to fall further is to sell it.

The third step is to set external portfolio risk management rules such as stop losses, or to always seek an independent second opinion or a financial risk assessment. There are different kinds of stop losses: absolute (“sell when the price drops below $12”) and relative (“sell when the price falls 20%”), and hard and soft stops — gradually downsizing one’s position after a soft stop loss level and fully liquidating it after a hard stop is reached. A good rule is to place a stop loss when an investment decision is made so that it is executed automatically when triggered. Stop losses help to achieve optimal investment decisions and minimise the temptation to circumvent the cognitive dissonance bias. The same is true for an independent second opinion — a trusted risk management framework motivates one to make the right decision. The key is that it must be unbiased. If your portfolio manager recommended the fallen stock, his advice is unlikely to be impartial. He is exposed to the same cognitive dissonance bias, and thus he might be unwilling to readily admit his prior mistake.

Finally, self-discipline is vital. Realising your bias and knowing how to overcome it is half the job. The other half is doing so systematically when investing.