Tuesday, December 1, 2009

Please, Just Lie to Me. A lesson on Financial Cognitive Dissonance.

Contributed by: Anonymous, aka: Curious George
What is cognitive dissonance?

Anxiety that results from simultaneously holding contradictory or otherwise incompatible attitudes, beliefs, or the like, as when one likes a person but disapproves strongly of one of his or her habits. (Dictionary.com)

It’s not so much the definition of cognitive dissonance but rather how we respond to it that is important. If investment decisions are built on untruths, results will suffer. Every day we are presented with conflicting information and we are conflicted in what to believe. If one wants good investment results then good information really does matter. So, where is the truth?

Social psychologist Leon Festinger says “Dissonance and consonance are relations among cognitions that is, among opinions, beliefs, knowledge of the environment, and knowledge of one's own actions and feelings. Two opinions, or beliefs, or items of knowledge are dissonant with each other if they do not fit together; that is, if they are inconsistent, or if, considering only the particular two items, one does not follow from the other” (Leon Festinger 1956: 25).

His three ways of dealing with cognitive dissonance

1. One may try to change one or more of the beliefs, opinions, or behaviors involved in the dissonance;

2. One may try to acquire new information or beliefs that will increase the existing consonance and thus cause the total dissonance to be reduced; or,

3. One may try to forget or reduce the importance of those cognitions that are in a dissonant relationship (Festinger 1956: 25-26).

Let’s try a real world example

After subprime mortgages melted down and delivered a severe blow to the economy, our economy is growing again and we are on the mend. The stock market reflects this belief and there is plenty of economic data that supports this position. If this is true then time will once again bail out investors from their ‘100 year storm’ losses for the second time in 10 years. This is what many of us believe. The market always recovers. Don’t time the market. If you miss the 10 best days… blah, blah blah.

So far so good. Now let’s add the conflicting information. On 11/30/09, U.S Debt Clock.org shows approximately $12 trillion in national debt and unfunded liabilities of $106 trillion totaling $118 trillion of total debt. Total annual GDP is approx $13 trillion. Total annual tax revenue is $2 trillion. We plan $1 trillion annual deficits for the next 10 years according to the government.

Total debt to revenue ratio is 59. If a household earning $100,000 annually had a debt to revenue ratio of 59, they would be $5.9 million in debt. This would be a problem.

Today total federal taxes are 15% of GDP. To eliminate the budget deficit taxes would need to increase 67% with no decrease in GDP to fix the problem. Does anyone believe this would fix our budget problem?

So, we have one stream of information sent to us every day telling us things are going to be fine or at least not so bad. Then there is this other set of facts that scream disaster. I don’t know about you but I am feeling anxious. This is cognitive dissonance. Now, review the three responses.

1. Change one of your beliefs to create consonance (harmony). Which stream of information do you believe?

2. Find new information to create consonance.

3. Try to forget about the information creating the dissonance or reduce its importance.

Response #1 means we judge some information and information sources as more relevant than the others.

Response #2 means we do more research.

Response #3 devolves into avoidance, Pollyanna, name calling or kill the messenger.

How we respond to cognitive dissonance may determine how successful we are and perhaps our financial survival. We don’t have to like it but we do have to deal with it.