Cognitive dissonance can explain investor actions

BY IAN OGILVIE Published: May 20, 2012

Have you ever held two seemingly incompatible beliefs at the same time? How about behaved in a way that is inconsistent with your view of the world? Chances are that you have. “Cognitive dissonance,” which describes a phenomenon that often applies to people in these types of situations, is a useful paradigm for understanding investors these days.

The term cognitive dissonance was coined by American social psychologist Leon Festinger in the 1950s.

The theory basically holds that individuals tend to seek consistency among their beliefs and behaviors.

When there is an inconsistency between these things, something eventually must change to make them consistent. Where a belief conflicts with a behavior, it is typically the belief that changes to conform to the behavior, since that is easier than the other way around.

The novel “The Plague” by Albert Camus provides a striking literary example of cognitive dissonance. The story tells of a plague that hits a city called Oran in northern Algeria. At the onset of the plague, the people of Oran witness rats dying in the streets, but they dismiss that omen as merely a bad dream.

Then, for a while during the early part of the pandemic, they go about their lives as before — until reality becomes unavoidable. Even though the people of Oran can see there is something wrong going on around them, they continue to act as if nothing has changed. Eventually their actions conform to reality and the dissonance is resolved.

Cognitive dissonance works the other way around too — instead of coming from a failure to adapt to changes for the worse like in “The Plague,” dissonance can come from failing to apprehend changes for the better. This is what is happening to individual investors today.

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