Updated July 27, 2023
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.
Example of Cognitive Dissonance
Examples of cognitive Dissonance are as follows:
Assume you have a client, David, who believes the markets are high on valuation and will fall in the next two months. You ask him for his opinion, and he believes the China market will drop due to a trade war. He formed his opinion based on the many articles he had read on various websites and newspapers. Based on these theories, he believes the market will go down.
You try to educate your client and tell him not to rely on these newspapers or magazines and should not make long-term decisions based on this. Even after the entire session, your client refuses to do so and cuts his position inequities to half. Immediately on the next day, the market fell 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 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 overcoming this behavior is to recognize this type of contradicting technique. Investors who understand these differences become better investors and can make better decisions.
Let us look at another example, assume that an investor believes that sell at the year-end and then disappear. This is a market anomaly. The investor believes that people sell stocks in this vacation period and makes the price down automatically. Therefore he does not sell in December as he thinks he will not get the best price.
In contradiction to his belief, he gets a call from his advisor, who tells him details of the stock of the company he owns. The company is going through a merger, and the shares prices have fallen 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 there is no selling in Dec and starts experiencing anxiety because this is against his thought process of cognitive dissonance example.
In this case, the advisor must help the investor overcome 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 stock’s current price 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 stock price falls only to $98, and you think 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 and the positive valuation. At this particular time, a sense of discomfort arises, and you experience cognitive Dissonance.
This is because the sudden jump in the stock price indicates that it was a good buy at $98. At least, this is what the market indicated it. There is a strong chance that you will price the stock at $110, and you rationalize that this is a good deal, thinking that the stock is trading at that price because the investors are ready to pay for it.
This is irrational behavior as; first, you thought that the stock was 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 behavior. A way to avoid this is that investors should stick to their decisions and not let emotions drive them.
Cognitive Dissonance is an emotionally driven bias that leads to this behavior. 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 behavioral of cognitive Dissonance starts to arise among investors.
One classic example is when the prices of shares move away from their fundamental valuation. This happened in the 2009 rally when the fundamentally down stocks were trashed in the market, including many financial institutions like banks, which have a lot of leverage on their balance sheet.
These stocks were the ones that performed well when proper monetary and policy actions were taken, and then the behavior of the market changed, and it all turned positive.
This idea contradicts the fact against choosing fundamentally good companies, and it is agreed upon that this phase lasts only for a short time and passes. Only fundamentally strong companies attract a premium. When making decisions, it is often necessary to prioritize rationality and objective perspectives over emotions and personal opinions.
Conclusion – Cognitive Dissonance Example
Portfolio managers utilize the term “cognitive dissonance example” in the field of behavioral finance to better understand their investors’ actions and help them address any issues. Cognitive dissonance Example is found in many finance factors rather than spending impulsively. Well-informed, smart investors exhibit this behavior when they experience low portfolio performance.
This has been a guide to Cognitive Dissonance Example. Here we discuss its definition, the examples of Cognitive Dissonance, and its detailed explanation. You can also go through our other suggested articles to learn more-