Investors, Are You Experiencing Cognitive Dissonance?

Suzanna de Baca -- Expert Business Source, 10/31/2008 8:37:00 AM

As an investor in today’s marketplace, are you focusing only on your losses? Are you obsessing about risk and wondering why you ever invested in equities? Have you sold stocks during the decline, hoping to find a safe place to park your cash? If this describes your current thinking about the markets, you may be experiencing what psychologists call “cognitive dissonance,” or the propensity to selectively filter information so that only negative experiences stand out.

In the book Investment Madness: How Psychology Affects Your Investing ... And What to Do About It by John S. Nofsinger, the author notes that when an investor experiences cognitive dissonance, their ability to sort out information is skewed. Investors tend to recall only the bad experiences or losses and their ability to evaluate investment choices becomes distorted. This is one explanation for panic selling and an inability to endure a painful decline in the market.

Cognitive dissonance is not exclusive to investing. It’s like a bad breakup. Sometimes when a relationship deteriorates and ends badly, it is impossible to remember that once, long ago, you actually had good times. You recall the name calling, blaming, and fights, and the memories of lovely walks on the beach or amiably sharing the Sunday paper are blotted out entirely. Similarly, in a market environment like we’re experiencing today, it may be difficult to recall that over the long-term, Americans have enjoyed positive returns despite numerous market corrections and downturns.

In my twenty years of working with investors, I’ve had plenty of opportunities to witness cognitive dissonance, although I didn’t always know the term. I just thought of it as selective memory, but now I’m glad I have a name for it because it feels much more scientific and official. Most often, I’d hear this selective memory regarding – not surprisingly – risk and return expectations.

When the markets are good, clients tend to state their risk tolerance level as low.  They assert with all seriousness that a 10-20% decline would not phase them. In addition, with the boom times bright in their minds, investors often declare that they expect high double digit returns while taking little risk. I remember back in the tech boom when people uttered in all earnestness that they expected the firm I was with at the time to earn a 20%-plus return on large cap equities. While that happened for a few years in a row, that type of return for large cap equities is not realistic over the long haul and certainly not any kind of historical average. In that era, I had people laugh at me for suggesting bonds although they’ve typically played an important role in the majority of individual investors’ portfolios.

Even pointing out historical returns barely convinces investors that high returns involve a great deal of risk and probable volatility. As we can see now, sometimes even beating inflation can be tough.

When the markets are bad the true risk tolerance of most individuals reveals itself. Suddenly, investors are happy to preserve capital at all costs. Bonds only, please! Or, Treasuries only!  Let’s put the cash under the mattress! The experience of investment loss –even if not realized by a sale -- can be devastating or evoke feelings of intense panic. The fear can block out all rationality and cause individuals to sell at the low, locking in losses, and flee to cash equivalents– safe, but which won’t necessarily beat inflation in the long run.

In times like these, trying to get a client to look at asset classes objectively is very difficult. Our decisions and preferences are colored by recent events, not by historical data that suggests we’ll recover from this downturn and that equities are the long term key to growth.

It can be helpful and healthy to take a step back and realize that our thinking may, in fact, be skewed by recent negative events. It can be instructive to try and look at investing from a much longer term perspective than just remembering the pain of the last year or the excruciating misery of the last month. 

We can control our thoughts and the way we choose to look at a situation, rather than being stuck in our reactive patterns. So, if you’re experiencing cognitive dissonance, consider taking a deep breath, looking at market history, and recognizing that the markets will recover and eventually trend upward, as they always have.

Suzanna de Baca is president of Private Capital Solutions Group. Securities offered through Broker Dealer Financial Services Corp. Member FINRA & SIPC. Investment Advisor Representative of Investment Advisors Corp., A Registered Investment Advisor. Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed reliable, please note that individual situations can vary, therefore the information should be relied upon when coordinated with individual professional advice.