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.
Things have improved a great deal since the end of the financial crisis: Retail sales, consumer confidence, business investment, home building and trade figures are all looking better.
Institutional and larger investors have recognized this and benefitted: The stock market has done quite well over the past three years.
But despite the fact that they are shopping, individuals still feel negative about things.
They tell pollsters they don’t feel good about their own prospects, and an almost 2 to 1 margin they complain the country is “moving in the wrong direction.” Even though the United States is experiencing steady if slow growth, people don’t seem to feel it; as recently as late April, 83 percent of respondents in one national poll said they felt the country was still in recession.
So what is the effect of this dissonance on investors, and what does it tell us? The world around us has improved considerably in the past three years, but people aren’t buying it. Individuals are shopping, but they’re not buying stocks. They’re willing to buy Polos but not Ralph Lauren.
Cognitive dissonance theory suggests that this dissonance will eventually be resolved: That at some point, either individual investors’ negativism will be confirmed, or they’ll come back to the market. Of course that explains why, should they choose to come back, they’ll be a bit late.
Ian Ogilvie works with a securities firm in Oklahoma City. Ralph Lauren is named merely as an example.