Cognitive Dissonance

Cognitive dissonance is the psychological discomfort that arises when a person's beliefs, attitudes or actions are inconsistent with one another, and the motivation to reduce that discomfort. Leon Festinger set out the theory in his 1957 book A Theory of Cognitive Dissonance. The financially relevant part is the direction of the repair: once a choice has been made and cannot easily be undone, people can bring their beliefs into line with the choice, by remembering it more favorably, stressing its good points or avoiding evidence against it, rather than revisiting the choice itself.

What it looks like with money. William Goetzmann and Nadav Peles tested the idea on mutual fund investors in a 1997 paper in the Journal of Financial Research. From questionnaire responses about recollections of past fund performance, they reported that "investor memories exhibit a positive bias" and that "the degree of bias is conditional upon previous investor choice, a phenomenon related to the well-known theory of cognitive dissonance." In other words, people remembered the funds they had chosen as having done better than they did. The same paper found "an unusually high frequency of poorly performing funds, consistent with investor 'inertia'".

How it relates to other biases. Dissonance is the discomfort; several better-known biases are ways of relieving it. Confirmation bias is seeking out evidence that supports what one already believes or has done. The ostrich effect is avoiding information, such as an account balance, that could make the conflict worse. The sunk-cost fallacy and the disposition effect describe staying with a losing course or position, for which dissonance is one motivation among several.

The sequence is a commitment, then conflicting evidence, then a repair. Reinterpreting the evidence asks less of a person than reversing the decision does, which is why it is the repair to watch for.

Take an example with invented figures. Renata invested $100,000 in an actively managed fund that charges 2 percent a year, or $2,000, and it trailed a low-cost index fund by several percentage points in each of the last three years. Selling would mean accepting that the original choice was a mistake. Holding on lets her keep believing it was sound, so she recalls the fund's one strong year more vividly than the three weak ones and stops reading the annual report. A rule she could have written when she bought, such as reviewing the fund if it trails its benchmark after fees over three years, would give her the answer without relying on a memory that dissonance has already edited.

Pros

• Recognizing dissonance explains why it is so hard to sell a poor investment or admit a purchase was a mistake.
• It points to a practical defense: fix the evaluation criteria before the decision, when there is nothing yet to defend.
• Understanding it can make it easier to review one's own past choices without treating every revision as a personal failure.

Cons

• The concept is broad, and almost any rationalization can be labeled dissonance after the fact, which limits how much it predicts on its own.
• Evidence that it shapes real financial behavior, such as the 1997 mutual fund study, is narrower than the general theory.
• Not every decision to stick with a choice is dissonance; sometimes the original reasons still hold.