Cognitive Dissonance: Where traders start to dig holes for themselves.

‘Cognitive Dissonance’ is a theory which states that we like to seek consistency in our beliefs within our mind. If we hold two conflicting or opposing beliefs we get a feeling of discomfort or unease, as such we attempt to reduce this dissonance in our minds caused by holding these two conflicting beliefs. This dissonance reduction may involve us self-justifying or deceiving ourselves, this includes acquiring or inventing rationales which resolve this internal conflict, or modifying previous held beliefs.

As mentioned, dissonance reduction often takes the form of a self-justification of self-deception. Some examples of this occur all around us, smokers typically display cognitive dissonance, they know it is bad for them, and that it will probably shorten their life, but they’ll reduce the dissonance and justify the smoking by thinking ‘It’s not really as bad as they say otherwise it would be illegal’ or ‘I’ll worry about that when I’m older’, etc.  Dieters will also fall victim to this, they may justify having a chocolate or piece of cake by thinking ‘Its just one, what harm can that do?’ Last year in the UK there was a major scandal involving expenses fraud by Members of Parliament, whilst passing anti-fraud legislation, they had no issue with this contradiction, claiming their expenses were entitlements. Police will often continue to prosecute suspects whilst wilfully ignoring contradicting evidence. Academics have been known to doctor research evidence to suit their arguments, explaining this away by firmly stating their conviction in their beliefs.

Cognitive dissonance is all around us, and is often intertwined with other biases and behavioural traits. In a sense procrastination is only achievable because we enact dissonance reduction. E.g. ‘I’ll do that piece of work later, after all what’s the rush’.

So what and how does these affect traders and investors directly?

I’ll provide some simple examples.

Firstly, assume I have a long position in the SP500 Index future, say I bought some contracts at 1250. I then placed a protective stop at 1240 whilst looking for an upside target at 1280. I have a personal trading rule that I never move a stop further away once it is in place. – Later that day, the SP500 is trading down towards 1242, I sense that my stop is too tight and that this will bounce. I have a cognitive dissonance, my original belief was that if the market traded down to 1240, I was out of this trade, I was not prepared to risk any more on this trade, based off my initial analysis. Now I am thinking that this may trade lower and then bounce, however I will be stopped out before then. My dissonance here is that I need to remove my stop and place it at a lower level, but I never move stops once in place, this is a ‘golden trading rule’ for me. However, I decide in this case that I can break the rule on this one occasion, my though process is ‘just once it won’t hurt, I have a really good feeling about this’.

Hence I move the stop to 1230. The best thing that could happen in this case, is to get stopped out at 1230 immediately, as I would have instantly been penalised, and should thus learn the error of my ways. But assume that instead the SP500 drops to 1235, the stop is not triggered, and the SP500 bounces and rallies to my target. – I will feel that I was justified in moving my stop, and hence will be almost certainly giving me the green light to repeat that. Thus now a sensible rule, put in place as a form of discipline is jettisoned, and a slippery slope has been started, almost certainly with disastrous future consequences for my trading.

Another trading example shows how self-deceit rather than self-justification can be the dissonance reduction technique. In this example, assume that a trader was playing the USDJPY carry trade in 2007, and had decided to go long USDJPY on a break over 121, convinced that this was heading higher to 132 and maybe higher. His conviction is built on that the fact that this has been trending higher 2 years, is buoyed by the fact that he is gaining nearly 5% yield pickup on a daily basis, and is boosted by the knowledge that just about every major player is in on this trade. - Briefly the USDJPY rallies to 124, he is making money and feels good, all the stars seem in line, and in his head he is thinking of the future rewards this will bring. But from 124 the USDJPY declines and breaks a key level at 118. Now he is sitting on a loss, and looking at analysis which is indicating a major reversal is underway.

The problem for the trader, in this example, is that he has attached himself to this position; he had in a sense bonded and indentified with it. His evidence firmly suggested that a deeper reversal is underway, but he decides to label this a minor correction. This new analysis had created a cognitive dissonance for him; he resolved the dissonance by trivialising his normal rational analysis and invoking a self-deception; he decided that ‘this time it was different’. (There are a couple of other cognitive biases at play here, - The endowment effect; valuing an asset more highly when we own it, and the previously discussed confirmation bias). Eventually this trade would have suffered a huge loss, USDJPY declined sharply to below 100.   

The problem with ‘dissonance reduction’ techniques is the use of ‘justifying terms’ – such as ‘just once’, or ‘this time its different. Of course we never do something ‘just once’, in fact usually when we break a rule, we tend to repeat breaking it, particularly if we’ve justified it and been proved right on that occasion.

In the Carol Tavris and Elliot Aronson excellent book, ‘Mistakes were made (but not by me)’, they talk about how this process takes hold in the creation of corrupt police practices. A good young highly principled cop sees an older cop plant some evidence. He is angry, confused and conflicted, but the older cop says to him ‘We’re the good guys, these criminals are getting away with crimes that we know they are committing, isn’t it better that when we know something and can not prove it, we make it provable, its not like we do this regularly, but in this case its different, it’s a one-off.’  The young policeman decides to look the other way on this occasion, just once. – A couple of years later, this happens again, but having already justified it previously he convinces himself of the value of this. Eventually some years later, without a hint of conscience, he is repeating this behaviour himself. – He may not necessarily be a corrupt cop, he may be a good cop who has adopted some bad practices, but either way it is quite likely that innocent people are going to prison somewhere, and guilty people are out running free.

Cognitive dissonance can be the loose thread, which slowly pulled over time ends up destroying a whole fabric. In a trading/investing sense this is often what can happen; a sensible reliable trading approach can start to come undone, and as in the first example above, it is not the initial action, but rather what it implies, where the problem often starts. In the second example, the self-deceit can lead to a warped view of the market. From my own experiences working with traders, cognitive dissonance can lead to traders digging themselves deeper and deeper holes and by the time they realise what has happened it may be too late.