Confronting Cognitive Dissonance In Your Portfolio
Written by David Fabian, June 18th, 2014
Everyone has core beliefs that make up who they are. Whether these views have been established by life experiences or are embedded in our psychology since birth, they color the way we see the world.
These core beliefs can also lead to an extreme bias that is hard to break. People get set on one idea or outcome to the point they ignore any evidence or data that flies in the face of their preconceived notions. Investors, like any other group, are just as guilty of these embedded expectations.
Frantz Fanon described this phenomenon best:
“Sometimes people hold a core belief that is very strong. When they are presented with evidence that works against that belief, the new evidence cannot be accepted. It would create a feeling that is extremely uncomfortable, called cognitive dissonance. And because it is so important to protect the core belief, they will rationalize, ignore and even deny anything that doesn’t fit in with the core belief.”
I often speak with investors that are so dead-set on an expected result from the market that they are unable to see any other outcome. They have rationalized their political, macro-economic, or market timing mentality into a state of conviction that is nearly unbreakable.
This often times leads to taking contradictory positions in stocks, bonds, or commodities with the expectation that the “top is in” or the “market is due to turn”. While this thesis might be sound on the surface, the results over the last several years speak for themselves.
Another outcome from cognitive dissonance is paralysis by analysis. Too many conflicting opinions creates indecision that leads to inaction. Staying in cash for an extended period of time will not allow you to reach your investment goals and will create further anxiety if trends continue to favor wealth creation.
Every dip in the SPDR S&P 500 ETF (SPY) since 2011 has been a buying opportunity rather than an opportunity to short the market. All you have to do is look at a price chart to realize that the trend is still intact and we are continuing to show positive catalysts for higher prices.
There most certainly will come a time when volatility rears its ugly head and we return to another bear market cycle. However, that theme has yet to materialize, which is why betting against the bullish trend has been so fruitless.
At the end of the day, the ultimate arbiter of reality is price. Price is the only thing that pays. You can throw out opinions, breaking headlines, confidence, sentiment, valuations, economic ratios, or any other indicator of where we are at in the current market cycle.
The market does not care where you or I think it should go and often reacts in a completely unpredictable way. That is why you have to be prepared for any eventual outcome if you want to be a successful investor.
Everyone has been wrong in their investing endeavors at some point in time. I often admit that I am too cautious when stocks are going up and not aggressive enough buying dips when those opportunities are presented. I find myself fighting those same “what if” scenarios in my head all the time. There is no shame in being wrong; there is only shame in staying wrong despite all evidence to the contrary.
Here are a couple of simple tips to overcome cognitive dissonance in your investment portfolio:
1. Don’t fall in love with any investment. You don’t want to become so enamored with a particular stock or ETF that you find yourself watching it fall out of bed or underperform. Try to be as objective as possible when looking at your existing positions to determine if they still warrant being in your portfolio.
2. Stop calling tops. Every week I see a new expert trying to tell us how stocks can’t possibly go any higher and to prepare for Armageddon in the markets. Know why? Fear sells. However, fear rarely makes you any money.
3. Create a watch list. You should have a watch list of positions that you are considering for your portfolio and comparing them to your existing holdings. Refresh these ideas on a regular basis as the markets change to make sure you are capturing new opportunities and setting price points where you will implement them. I recently purchased the Vanguard Emerging Market ETF (VWO) for my growth-oriented clients because it was a holding on my watch list that I actively monitored and met the price targets I established.
4. Manage risk with stop losses. In investing there are four possible outcomes: (1) a big gain, (2) a small gain, (3) a small loss, and (4) a big loss. The first three outcomes are acceptable. However, you always want to avoid a big loss that can set you back significantly. I always recommend setting a trailing stop loss or other sell discipline to define your risk and delineate a clear exit strategy.
5. Stay balanced. While it may not always be possible to clearly “see both sides of the trade” based on our core beliefs, you should keep a balanced mindset when constructing your portfolio. Confidence and discipline can be used effectively to implement new investment ideas. However, an overabundance of greed, fear, or conviction can wreak havoc on your nest egg. Consider building your portfolio with multiple asset classes as another method of diversification and risk management.
While there is no perfect formula for the stock market, there are disciplined steps you can take to improve your outcome. The first undertaking on that journey is to become self-aware of any ideological bias that may have worked against you in the past and fight to overcome it in the future. That way you are better prepared to take advantage of new opportunities when they come your way.
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