In any investment category there is invariably a broad spectrum of views, many of which are in outright opposition. This article by Nick Armet, an investment director at Fidelity Worldwide Investment, looks at behavioural problems and suggests some practical workarounds for investors and their advisers.
Cognitive dissonance is the feeling of discomfort we have when faced with holding two or more conflicting thoughts, beliefs or emotions. Given the human desire to avoid mental discord, we have a strong motivation to rationalise conflicting thoughts away so that we are left with a harmonious, unified view.
The problem is that in order to reduce the dissonant feeling we can become biased towards self-deception. We can be drawn into simplifying narratives or illusions, or become guilty of rejecting valid but contrary viewpoints out of hand.
While the term cognitive dissonance is modern, the principle behind it is reassuringly old. Aesop’s fable of the The Fox and the Grapes is one of the earliest expressions of the desire to rationalise away two incompatible truths. When the fox realises he cannot reach the grapes high on the vine, he decides he does not want them after all – explaining the about-turn to himself with the new thought that they are probably sour anyway.
American psychologist Leon Festinger took up the thread of this fable in the 1950s when he conducted several experiments that subsequently established him as the father of modern cognitive dissonance theory. He put forward two ideas: first that we are motivated to reduce dissonance in our thinking; second that we will actively avoid information that would increase dissonance.
The scope for mental conflict in investment is obvious. On any investment category or security, there is invariably a broad spectrum of views, many of which are in outright opposition. Indeed, the sheer amount of information available today means there is also considerably more fuel for disharmony to rear its head, making the problem of cognitive dissonance more acute than ever.
Moreover, the financial crisis put us into uncharted territory with unprecedented monetary easing and high debt levels polarising economists’ views on the need for growth versus austerity and the prospects for inflation or deflation.
Buyer’s remorse
If there is uncertainty in terms of where we go next, there is also complexity when it comes to what to invest in. A problem related to cognitive dissonance is the paradox of choice – a theory put forward by American psychologist Barry Schwartz, which claims that after a certain threshold is reached, an increase in the number of choices may cause psychological distress. In turn, this can lead to something called buyer’s remorse.
This is the sense of regret that flares up after a purchase decision, which involved a choice between several valid options. It can be associated with the purchase of an item such as a car or a house or an investment in a particular asset, fund or security. It is an example of post-decision dissonance, where a person seeks to decrease their discomfort to a made decision. The buyer may change their behavior, their feelings, and their view about the world. The dissonant feeling can lead to self-deceptions to restore harmony that can make us irrationally overconfident of the investment position we have taken.
Cognitive dissonance is something of a root bias within behavioural finance that can lead to a range of other self-deceiving biases such as narrative fallacy, confirmation bias, overconfidence and the illusion of control. It can make us unwilling to sell out of a losing position or unwilling to review a position that no longer looks quite as attractive as it once did.
Tips for investors
So what are some practical workarounds for investors? First, by undertaking careful research and scenario planning, we can set out an investment policy and process that takes account of various scenarios that we want to give weight to. As with all behavioural biases, investment process is a key defence.
Second, there should be recognition that in investment, it is valuable to search out and weigh up discordant thoughts or views. By deliberately taking the opposite view, we can test the strength of our assumptions – if you are bullish, take time to understand the bearish view and vice versa. Despite the fact that it increases dissonance, investors should be prepared to occasionally fight their emotions by embracing the contrarian view when the market pendulum swings too far in one direction. This means going against the herd by taking profits when everyone is buying and valuations are stretched. And it means buying when the herd is selling and stocks are cheap.
We know that in investment markets, incompatible and opposing views, scenarios and market patterns are commonplace so the scope for dissonance to take root is significant. Indeed, successful portfolio diversification across assets is only possible if you are able to embrace opposing views and scenarios, so that your portfolio is exposed to growth but also resilient to slowdown.
Multi asset products can offer a simple and effective way of dealing with discordant scenarios and views. By investing in a range of safe and risky investments with different risk and reward characteristics, we can avoid the binary pain – or ‘buyers remorse’ – associated with putting too much of our firepower in one asset class.
Investment philosophy must trump emotion
Stock markets regularly act in unexpected ways – this can also stimulate dissonance. One example is when share prices diverge from fundamentals. This happened in the 2009 “trash rally”, when the fundamentally worst, most beaten-up stocks in the market – including financial companies with the highest leverage on their balance sheets – subsequently performed the best when concerted policy actions were announced and market sentiment turned positive.
This is incompatible with the idea of picking the most fundamentally attractive companies, but we can take solace from the fact that such phases are rare and stock fundamentals tend to win out in the end. In the long run, it’s the strongest companies that attract a premium. Again, adherence to investment philosophy is a valuable defence against dissonant views and emotions.
Lastly, consider also the huge monetary stimulus undertaken by central banks. Most recently, the Bank of Japan surprised the markets by announcing its intention to double its monetary base as part of an aggressive monetary policy to target inflation. Since that announcement, the gold price has fallen when many investors would have expected it to rise. The two things seem incompatible. Is gold reacting to a better outlook for economic growth and ultimately higher real interest rates? And if that is the case, then why are bond yields still near record lows?
The scope for dissonance in the present financial markets is evident and the lure of applying simplifying narratives easy to fall into. Disentangling the implications demands a continuous and disciplined fundamental research effort that relatively few investors are able to manage.