Posts filed under “Psychology”

Cognitive Dissonance Is Hurting Your Returns

Regular readers know I enjoy discussing behavioral aspects of investing. The reasons for this are twofold: First, we can’t control the markets, but we can control our own reactions to it (at least we can try). And second, many studies have shown that investors suffer from a behavior gap between what they should garner in returns and what they actually get.

Of all of the failings of human wetware, the one I find most intriguing is cognitive dissonance. You can find technical definitions at Changing Minds, The Skeptics Dictionary or any number of other reference books.

In the context of economics and investing, my preferred definition is as follows: Cognitive dissonance occurs in the mind of an individual when a theoretical belief system is confronted by factual evidence demonstrating outcomes contrary to what theories dictate should occur.

Stated more plainly, when facts conflict with beliefs people find ways to ignore those facts, rationalizing them in a way that allows the disproven ideas to survive. John Kenneth Galbraith famously referenced cognitive dissonance before it was even called that, stating “Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof.”

I was reminded of this recently courtesy of several seemingly disparate but cognitively-related articles. The New York Times discussed the idea in “When Beliefs and Facts Collide”; my colleague Michael Batnick focused on cognitive dissonance and investing in “Climate Change and the Efficient Market Hypothesis.”

Consider the following: Much of what we do is predicated upon a specific abstract belief system. Investors and traders hold and act on a tremendous range of philosophies — from value investing to market timing, stock selection, momentum trading, chart reading, etc. All of these have their positives and negatives, but none of them excel all of the time in all markets. Hence, we are often confronted with data that conflicts with the basic philosophy that we use to govern how we deploy our capital.

The important aspect of this is how we respond to this conflict. We can rationalize the data, or we can accept the facts and make changes to our beliefs.

Examples are many and varied: Deep value investors who buy depressed stocks without regard to other risk factors, only too see them fall another 50 percent; buy-and-hold investors who get demolished in a bear market, only to sell out at the bottom; radical deregulation resulting in bad outcomes rather than the free market nirvana its believers espoused; Austrian economists warning of imminent hyperinflation and the collapse of the fiat dollar that never arrives.

Rather than question the theory, the person suffering from cognitive dissonance ignores the facts in front of their very eyes and instead devises rationales for why any specific expected outcome never occurred. The blame is laid elsewhere, never on their disproven thesis.

Perhaps my favorite example came about after housing-market collapse. It wasn’t the wildly irresponsible behavior of non-bank lenders and junk mortgages securitized and rated AAA that caused the problems. Rather, it had to be something else, and if we can find a government entity to blame, so much the better. Watching the endless attempts to throw something against the barn door to see what might stick would have been amusing if it were not so sad: It was the Community Reinvestment Act! No wait, it was the FHA’s VA loans. No, it was Fannie and Freddie!

The grim reality was much more complex. Many factors deserve blame, ranging from ultra-low interest rates, falling real incomes and a mad scramble for yield. These combined with the deregulation of the past decades created a unique set of circumstances that allowed traditional lending standards to fall by the wayside. You know how all of that ended.

Refusing to acknowledge the complicated reality once it conflicts with your belief system is a classic example of cognitive dissonance. If you can’t face the reality of the housing collapse, cook up some story that explains what happened consistent with your ideology. That it might be very easily debunked is beside the point.

We see this manifested in many ways in investing and trading. There is a fine line between having confidence in your methodologies and living in your own private fantasy world.

Like it or not, this is the human condition. Recognizing it at least gives us a chance to avoid getting caught in its pernicious grasp.

In investing, just because you have human failings doesn’t mean you have to act upon them.

Category: Cognitive Foibles, Investing, Psychology

Tales of the Death of Hedge Funds Have Been Greatly Exaggerated

During the past few months, we have posted a few words here on the quandary that is hedge funds. One such effort was titled “The Hedge-Fund Manager Dilemma,” and it explored the public’s fascination with the hedge-fund crowd. The next, “Why Investors Love Hedge Funds,” looked at why, despite stunning underperformance during the past decade,…Read More

Category: Hedge Funds, Investing, Psychology

Masters in Business: Rob Arnott of Research Affiliates

Rob Arnott turned the world of passive index investing upside down. Best known for creating “smart beta,” Arnott creates models weighted b y four factors: Sales, profits, book value and dividends. Market cap is not relevant to him. Funds running Arnott’s models manage about $200 billion dollars in smart-beta strategies. Assets have increased by 59…Read More

Category: Financial Press, Index/ETFs, Investing, Psychology

Nick Epley: Why You Should Talk to Strangers

Nicholas Epley is the John T. Keller Professor of Behavioral Science at the University of Chicago Booth School of Business. He was named a “professor to watch” by the Financial Times, is the winner of the 2008 Theoretical Innovation Prize from the Society for Personality and Social Psychology, and was awarded the 2011 Distinguished Scientific…Read More

Category: Psychology, Weekend

How to Change a Habit

Click for the ginormous version. Source: Charles Duhigg

Category: Digital Media, Psychology

It’s a Bubble! It’s a Recession! It’s a Crash!

When was the last time anyone got good investing advice from the front page of a newspaper or magazine or from a television pundit? That is the question I have been pondering during this market cycle. Whether it is the price of equities or the state of the economy, I have grave reservations about relying…Read More

Category: Cognitive Foibles, Financial Press, Markets, Psychology, UnGuru

What to Do in a Market Correction

Things to try in a market correction: • Respond emotionally, giving in to your lizard brain. It does a good job of keeping you alive, so you might as well hand over management of your portfolio to it. • Rely on your gut instinct to lead you out of trouble. After all, your instincts helped…Read More

Category: Cognitive Foibles, Investing, Markets, Psychology

Personality Research Says Change in Major Traits Occurs Naturally

Source: WSJ

Category: Digital Media, Psychology

Single Variable Market Analysis is for Losers

If you work in finance, you will invariably come across an example of single-variable analysis. Almost daily, we see terrible examples of this sort of analytic error, rife with logical weakness, yet offered with the highest degree of certainty. The way this works is as follows: Some ominous data point will be shown, along with…Read More

Category: Analysts, Data Analysis, Investing, Philosophy, Psychology, Quantitative, Really, really bad calls

Last chance to sign up for today’s MTA presentation!

MTA Presentation: Risk, Trading & Neurofinance: “This Is Your Brain On Stocks” Click through for the free registration:   MTA New York Chapter Meeting June 23, 2014 Featuring Barry Ritholtz presented by Bloomberg L.P. The New York Chapter of the MTA invites you to our next chapter meeting on Monday, June 23, 2014. We are…Read More

Category: Cognitive Foibles, Psychology, Trading