Definition Of Cognitive Dissonance Example
Cognitive Dissonance is an emotion that is unpleasant and which comes from having and believing in two different or contradicting emotions at the same time. This kind of emotion leads to irrational decisions as the individual tries to make the right decision with two conflicting emotions or beliefs. In this article, we will discuss the different Cognitive Dissonance Example.
Example Of Cognitive Dissonance
Examples of cognitive dissonance are as follows:
Assume that you have a client David who believes that the markets are high on valuation and are going to fall in the next two months. You ask him for his opinion and he believes that China market is going to go down due to a trade war. He formed his opinion based on the many articles he has read on various websites and newspapers. Based on these theories he definitely believes that the market is going to go down.
You try to educate your client and tell him not to rely on these newspapers or magazines and should not make your long term decisions based on this. Even after the entire session your client refuses to do so and cuts his position in equities to half. Immediately on the next day, the market falls down by 5% based on China and the US’s trade war. David believed what he did was right.
After a fortnight the market rebounds again and the global economy is very strong. As his advisor, you ask David to rebalance the portfolio again and stick to his long term plan by investing in equities again. David now regrets his decision and realizes that he has made a mistake but is not in a position to acknowledge his mistake.
This is a classic case of cognitive dissonance. The first step to overcome this kind of behaviour is that is to recognise this type of contradicting techniques. Investors who understand these differences become better investors and can take better decisions.
Let us look at another example, assume that an investor believes that sell at the year end and then disappear. This is basically a market anomaly. The investor believes that people but sell stocks in this vacation period and makes the price down automatically. Therefore he does not sell in December as he believes he will not get the best price.
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In contradiction to his belief, he gets a call from his advisor and tells him details of the stock of the company he owns. The company is going through a merger and the prices of the shares have fallen down dramatically. According to the investor, he should sell his stock immediately. According to his belief, the investor checks the date as December 5th, he goes by his logic that no selling in Dec and starts experiencing anxiety because this is against his thought process of cognitive dissonance example.
In this case, the advisor will have to help the investor in overcoming this belief and his desire not to sell in December.
Consider you own a stock that you wish to buy because according to you the company has very good valuations. The current price of the stock is close to $100 and you think that you will buy the stock when the price falls a little down say to $95. In line with your belief, the price of the stock falls, however, only to $98 and you think that the target of $95 is still achievable.
According to your disbelief, the stock jumps to the price of $110 the next day because of the positive global clues along with the positive valuation. At this particular time, a sense of discomfort starts arising and you experience cognitive dissonance example.
The reason for this is that the sudden jump in the price of the stock indicates that it was a good buy at $98. At least this is what it was indicated by the market. There is a strong chance that you are going to price the stock at $110 and you rationalize yourself that this is a good deal, thinking that the reason the stock is trading at that price is because the investors are ready to pay for it.
This is irrational behaviour as first you thought that the stock is only a good buy at $95, therefore, it is not a good buy at $110. However, convincing yourself that it is a good buy at $110 just because other investors are ready to pay that price is irrational behaviour. A way to avoid this that investors should stick to their decisions and not let emotions drive it.
Cognitive dissonance is an emotionally driven bias that leads to this kind of behaviour. This can lead to investors buying and selling based on their emotions which should be avoided.
Let us look at a practical example from the past. This is known that the markets react in unexpected ways. This is generally when the behaviour of cognitive dissonance starts to arise among investors.
One classic example is when the prices of share move away from their fundamental valuation. This is what happened in the 2009 rally when the fundamentally down stocks were trashed in the market including the many financial institutions like banks which have a lot of leverage on their balance sheet.
These stocks were the ones which actually performed well when proper monetary and policy actions were taken and then the behaviour of the market changed and it all turned positive.
This idea is contradicting to the fact against choosing fundamentally good companies and it is agreed upon that this phase lasts only for a short time and passes by. Only fundamentally strong companies attract a premium. This is only possible when decisions are made against emotions and views.
Conclusion – Cognitive Dissonance Example
- Cognitive dissonance Example is a term used from behavioural finance which helps the portfolio managers understand the behaviour of their investors and help them overcome it.
- Cognitive dissonance Example is found in many factors of finance rather than just spending impulsively. This behaviour is also reflected in well informed smart investors when the performance of their portfolio is low.
This has been a guide to Cognitive Dissonance Example. Here we discuss its definition and the examples of Cognitive Dissonance along with its detailed explanation. You can also go through our other suggested articles to learn more-