Why Some People Make Bad Financial Decisions

Why Some People Make Bad Financial Decisions

When I was a teenager I was a fan of science fiction. I recall reading one story about an attempted takeover of the world by a bad guy using warrior robots. His nefarious plan was thwarted by the good guy who discovered a way to cause the robots to self-destruct. The solution involved feeding conflicting information into each robot, preventing their ability to think rationally and forcing them into a vegetative state. In the end everyone (except of course the bad guy and the robots) lived happily ever after.

It turns out that may not have been complete fiction.

The term “cognitive dissonance” was coined by psychologist Leon Festinger in 1957. It refers to the way a person behaves when holding two beliefs that are contradictory. Unlike the robots, we humans can overcome the mental stress by justifying both beliefs via rationalization and/or by rejecting any additional information (factual or otherwise) that increases the magnitude of the dissonance. Put more simply, we are not restricted to thinking rationally.

One example of this is playing out in national politics right now with the January 6th Select Committee hearings on the causes of the insurrection that took place in the U.S. Capitol on that date. Supporters of Donald Trump would be facing cognitive dissonance if they accepted the Committee’s assertion that Trump illegally tried to overturn the results of the 2020 election. They will likely be forced to reject either their support of Trump or the Committee’s findings, facts notwithstanding. (Note that cognitive dissonance does not apply to politicians who intentionally lie because they believe doing so will help keep them in power. That may be reprehensible but psychologically it’s totally rational).

Cognitive dissonance can also play an important role in financial decision-making. Take cryptocurrencies. Some investors strongly believe that they are a very good hedge against inflation and against stock market crashes. If that were true, this would have been the time for them to soar. Instead bitcoin and etherium (among others) are experiencing one of their biggest collapses in value since inception, significantly worse than that of stocks or bonds. How will cryptocurrency fans react? Some will now accept the unpredictability of cryptocurrency performance and learn to modify their investment allocations accordingly. Others will rationalize why the hedge didn’t work this time but will remain convinced that it will work in the future.

I believe the safest approach to investing is to develop some core beliefs that have stood the test of time. Mine are quite simple:

  1. Nobody can predict the future or guarantee future stock returns.
  2. Which means nobody can consistently pick stocks that will outperform the market.
  3. And nobody can consistently time when to get out of and back into the market.
  4. So your investment strategy should focus on what you can control: risk, cost, and taxation.
  5. And your investment strategy’s balance between risk and return should be dictated by your future lifestyle goals.

I regularly search for counter-examples of #2 and #3 but have yet to find any. Regardless I remain open to modifying any of these beliefs if/when I encounter new evidence to the contrary. Avoiding overconfidence bias can be just as valuable as avoiding cognitive dissonance.

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