Cognitive Dissonance & Personal Finance

by James & Miel on September 11, 2009 · 1 comment

Psychology plays such a huge role in how we manage our personal finances, and yet it is often overlooked when attempting to explain our behavior. We’re often told to not let emotion get in the way of making solid financial decisions, but what exactly does that mean? A major psychological effect that a lot of us experience when investing is something called “cognitive dissonance”.
Cognitive dissonance occurs when someone holds two contradictory ideas or behaviors at the same time. Having two contradictory ideas, beliefs or behaviors at the same times causes such feelings as anxiety, guilt, anger and embarrassment, and often leads to the individual attempting to rationalize in an effort to resolve the apparent conflict.

The most famous example of cognitive dissonance is one of Aesop’s fables, the story of the Fox and the Grapes. In the story, a fox comes across some grapes. He tries to reach them, but is unable to. He finally gives up, rationalizing that they looked sour anyway. In the story, the fox had two contradictory ideas and actions (the desire to eat the grapes and the inability to reach them), which caused him enough stress that he had to reconcile the issue by asserting that they looked sour, despite the fact that they weren’t.

Cognitive Dissonance appears in all aspects of our lives. With regards to money, examples can be found in two major areas: how we spend our money and how we invest our money. As a personal example, my contract with Verizon recently came up. The phone I had up to that point was perfectly fine. It worked great, there were no major problems and in fact, it was only about a year old, as the first phone I bought on that 2-year contract had broken a year ago and had to be replaced. There wasn’t going to be a penalty for not re-signing my contract; I would pay the same amount and outside of a few pestering phone calls from the Verizon folks, there really wasn’t going to be much of a difference between being on a 2-year contract and not in the short term.

So the rational thing to do would be to keep my old phone while it still worked (and I was happy with it) and when I actually needed to get a new phone, I could. I would have the added benefit of deferring the inevitable cost of a new phone, and by holding out, I might wait long enough for something cool like the Palm Pre or the iPhone to come out on Verizon’s network.

So what did I do? I went ahead and renewed my contract the day it was up, thus allowing me to get a sweet deal on the BlackBerry Tour, of course. The benefits of not signing a new contract right away directly conflicted with my strong desire to buy the coolest new technology. Ultimately, I told myself (and my skeptical wife) that my old phone was probably going to break soon (it wasn’t) and the new BlackBerry had so many cool features that it was worth it (somewhat true). That rationalization was all I needed to resolve the issue between those two thoughts, and two days later I was setting up my new phone.
This cognitive dissonance created while spending money can cause anxiety leading up to the purchase (“I know I shouldn’t but…”) and shame and guilt afterwards (“I probably shouldn’t have spent that much money on that”). How we resolve those feelings is to justify it.

Common justifications I use are: “It was on sale”, “I’ve been thinking about buying one for a while”, “I deserve something new and shiny”, etc… Being able to justify our actions (whether it’s a solid justification or not) alleviates that guilt and we’re free to enjoy what we’ve purchased, even if in the long term that decision is proven to be the wrong one.

But it’s not just our spending choices that can bring about cognitive dissonance. It’s often seen in our investment choices. William Goetzmann and Nadav Peles wrote an excellent paper published in the Journal of Financial Research entitled “Cognitive Dissonance and Mutual Fund Investors” where they attempted to understand why investors continue to stay with poorly performing funds, despite the fact that logically, they should move their money elsewhere. In the past, this behavior had been attributed to a number of different factors, such as high transaction costs, poor research, general irrationality, etc… and while not completely discounting the influence of those factors, they explored possible psychological explanations for that behavior.

They did this by surveying two groups of mutual fund investors, and found that even the most respected and well-informed investor tends to alter their perception of the past poor performance of their investments. Cognitive dissonance is all about people revising their attitudes about a certain idea in an effort to reconcile logical contradictions. When the opportunity presents itself to make those revisions, investors tends to take it, thus allowing them to feel a greater level of comfort about their decision, which in turn allows them to stick with the poorly performing fund for a longer period of time. The referenced paper is more extensive than I have presented here, and it’s definitely worth checking out if you’re interested in this subject.

This begs the question: how do we avoid falling into this trap? First of all, it’s impossible to completely avoid this manner of thinking. Financial decisions are rarely black and white, and everything is a cost-benefit analysis, so there will always be logical wiggle room when presented with scenarios such as the ones described above.

The key is to recognize when we’re making a logical leap. As with every financial decision, careful planning and recognition that our emotions and psychology affect how we behave is a crucial step in ensuring that we don’t fall victim to irrational behavior that will prevent us from building wealth.

-Michael
Twitter: @michael_DINK

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