Cognitive Dissonance in Investing: Why You Can't Admit You Were Wrong
You know that feeling when you buy something and then find out there was a better deal elsewhere? That little knot in your stomach? Congratulations, you just experienced cognitive dissonance.
Pompian opens Chapter 4 with a Shakespeare quote about being true to yourself. Good choice, because cognitive dissonance is basically our brain lying to us so we can feel good about our decisions.
What Is Cognitive Dissonance?
Here’s the thing. Cognitive dissonance happens when new information conflicts with what you already believe. Your brain does not like this conflict. It creates mental discomfort. So your brain does what any lazy system would do. It finds a way to make the discomfort go away.
The classic example Pompian gives is buying a phone. You buy Brand A. You think it is the best phone ever. Then someone tells you Brand B has better features. Suddenly you feel uncomfortable. Did you make a mistake?
Most people don’t go research Brand B honestly. Instead they start listing all the reasons Brand A is actually better. They convince themselves they made the right choice. They literally rewrite reality in their heads.
This is cognitive dissonance in action. And it is the foundation for all belief perseverance biases in this book.
Two Flavors of This Bias
Pompian describes two aspects that matter for decision making.
Selective perception. You only notice information that confirms your decision. Everything else gets filtered out. You literally cannot see the full picture because your brain is editing it for you in real time.
Selective decision making. You keep doubling down on your original choice even when the cost is ridiculous. This is the “throwing good money after bad” problem. You already invested $10,000 in a failing stock, so you put in another $5,000 because selling would mean admitting the first $10,000 was a mistake.
Both of these are your brain trying to protect your ego.
The Smoking Example
I love this example because it is so simple. Everybody knows smoking causes cancer. Smokers also want to live long lives. These two ideas create massive cognitive dissonance.
So what do smokers do? They rationalize. “It won’t happen to me.” “Only heavy smokers get sick.” “Something else will kill me first anyway.”
Sound familiar? Investors do the exact same thing with bad investments.
How This Hits Your Portfolio
Here’s the problem. Pompian lists four specific ways cognitive dissonance messes with investors:
Holding losers too long. You can’t sell because selling means admitting you were wrong. The mental pain of being wrong is worse than the financial pain of losing money. Think about that for a second.
Averaging down without thinking. Your stock drops, so you buy more. Not because you did new analysis. Just because buying more confirms your original decision. “I’m not wrong, I’m just getting a better deal now.”
Herd behavior. People ignore bad information about their investments for so long that when reality finally hits, everyone panics at the same time. This creates those massive sell-offs you see in the news.
“It’s different this time.” Remember the dot-com bubble? People bought insanely overvalued stocks and ignored every piece of evidence that said these companies were worthless. Because admitting the truth would create too much dissonance.
The Mutual Fund Study
Pompian references a fascinating study by Goetzmann and Peles from Yale and J.P. Morgan. They looked at why investors stick with losing mutual funds.
So here’s what happened. They found that investors actually misremember how their funds performed. Their memories have a positive bias. People literally remember their investments doing better than they actually did.
The study also showed something interesting about fund flows. Money pours into winning funds fast, but people are really slow to leave losing funds. Why? Because leaving means admitting you picked wrong. Cognitive dissonance keeps you stuck.
Goetzmann told CNN in 1998: investors “are selective about the information they collect about their mutual funds. People like to think that they made a good choice.”
That sentence is basically the entire chapter in 25 words.
Three Ways People Cope (Badly)
When cognitive dissonance hits, people usually do one of three things. All of them can hurt your investments.
They change their beliefs. “Actually, it is okay to hold a losing stock.” You literally rewrite your investment rules to justify a bad position. This is the least common response in finance, but it happens.
They modify their actions through fear. You scare yourself into never making the same mistake again. This sounds good in theory. But the problem is that over time you get numb to the fear, and you go right back to the old behavior.
They rationalize the action. “I don’t really need the money right now, so I won’t sell.” This is the most dangerous one. You create a story that makes holding a loser seem reasonable. Pompian says this attitude must be avoided.
What To Actually Do
Pompian’s advice is straightforward. When you feel that mental discomfort about an investment, don’t run from it. Run toward it.
Analyze the decision honestly. If your fears are correct, face the problem directly. Sell the loser. Take the tax loss. Move on.
The bottom line from this chapter: people who can recognize cognitive dissonance become much better investors. The ones who can’t recognize it keep repeating the same cycle of anxiety, denial, bad decisions, more anxiety.
I spent 20 years in IT, and I can tell you this pattern is not just about investing. I have seen engineers defend obviously broken architectures because they designed them. I have seen entire teams stick with failing projects because nobody wanted to be the person who said “we were wrong from the start.”
The brain protects the ego at all costs. In investing, those costs are very real and very measurable.
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Next: Conservatism Bias
This is part of a series retelling “Behavioral Finance and Wealth Management” by Michael M. Pompian. Start from the beginning.