Cognitive Dissonance and Behavioral Finance

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Introduction

The cognitive dissonance theory explains the phenomenon where a person experiences tension and anxiety when that person has two opposing thoughts in mind. Dissonance is directly proportional to the importance of a certain ideology, intensity of opposing views and absence of rational decision making. When a person believes something quite strongly and acquires knowledge which is in contradiction with this belief the person feels tensed in making a choice between the two cognitions. Cognitive dissonance is the discomfort or tension a person feels after acting against the personal belief system.

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When a person faces two differing ideologies and is forced to make a decision to choose one of these ideologies the person may change the current personal belief system or behavior, justify the current behavior by changing the newly acquired opposing cognition or justify current behavior by acquiring additional cognitions. The level of cognitive dissonance is strongest when self image of a person is involved. If a person performs an action which cannot be reverted, then that person tries to change his/her beliefs in order to adapt to the differences created by the performed action.

When dissonance starts a person needs to reduce it depending on the level of differences between the two cognitions. It is generally difficult to change a cognition which relates to a person’s behavior. When behavior is inconsistent with attitudes the dissonance is reduced by changing attitudes rather than changing behavior (Cooper, 2007). This paper explains cognitive dissonance in context of behavioral finance by analyzing an article which focuses on the effects of cognitive dissonance on behavioral finance.

Application of Cognitive Dissonance with Practical Implications

Cognitive Dissonance occurs either when there are conflicting ideas in a person’s mind or when a person acts against a personal belief system. There are several real life examples which imply that cognitive dissonance can be applied either to change a person’s belief system or to strengthen it. As a result of dissonance a person makes a choice between established beliefs or contemporary changes in an industry or business. It is usually seen that people are reluctant to change and tend to follow established norms and beliefs either in personal or professional lives. A research study showed how cognitive dissonance could be used to enhance customers’ trust regarding online purchasing.

The study found that if customer satisfaction level was high companies could further strengthen this belief and retain online customers and if customer satisfaction and trust levels were low companies could provide proof that they were different from others to gain customer confidence (Kuan, Bock, & Lee, 2007).

There are other real life examples which indicate that individuals and businesses are affected by cognitive dissonance. People usually forego personal beliefs and what they think is correct to match group norms so they could be seen as members of that group which implies decisions made on cognitive dissonance. As most people are optimistic about their investments even in poor economic conditions they tend to hold on to stocks with the expectations that the stock market will eventually recover.

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When eventually they do sell these stocks they are acting against their own belief that the market will recover. When there are conflictions in personal characteristics such as behavior and attitude the level of dissonance is highest and people tend to make decisions based on historical patterns rather than newer ideologies. This entails that people make decisions based on incentives or benefits they derive from the actual shift. If this amount is significant then a person may change based on higher benefits derived from the change. Cognitive dissonance can be used in various real life instances either to motivate or prevent people from acting in a particular way.

Summary of Article

The article written by Robert A. Olsen entitled Cognitive Dissonance: the Problem Facing Behavioral Finance presents the relationship between cognitive dissonance and behavioral finance. The article starts with an introduction of cognitive dissonance and behavioral finance. The article argues that cognitive dissonance causes several problems in behavioral finance and decision making. The writer suggests that there are two schools of thought regarding behavioral finance.

Olson argues that cognitive dissonance is a major problem in finance based researches and traditionalist resist any major changes in the research framework and tend to follow established norms and theories and any deviations from established paradigm are highly criticized. The article highlights four broad traditional finance models and argues that these themes though are quire relevant but do not present efficient results.

The first model presents that optimization can be achieved in uncertainty with application of scientific methods. The second theme is based on a proposition that the human brain functions like a problem solving device and can be trained to make logical decisions. The third theme outlines that human emotions have a negative effect of decisions and the final theme presents the notion that human beings are selfish and tend to make decisions based on personal gain.

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The article critically evaluates these four themes and points out several flaws in these themes such as lack of proof and detailed explanation in the first model, irrational decision making by human beings even after training as suggested in the second model and importance and relevance of emotions in decision making as opposed to the third model. Olsen also explains that several researches have shown that people make decisions based on what a particular group or society as a whole perceives.

This phenomenon is seen in financial markets where people usually tend to follow the crowd whether the crowd makes rational or irrational decisions. The writer presents this notion in criticism of the last traditional financial model which explains that decisions are based on personal gains.

The article compares traditionalist and behavioral views regarding other models and themes. Traditionalists regard financial risk as the variances in returns and investment whereas behavioral finance suggests that financial risk is a human perception based on several characteristics and decisions are made based on two processes. Another theme discussed in the article is the phenomenon of herding and crowd following. Traditionalists suggest that following a certain group and making decisions based on decisions made by a reference group is rational. Behavioral finance practitioners on the other hand suggest that herding and crowd following is based on a much larger theme rather than decision making. The last theme outlined in the article is overreaction which compares different interpretations under traditional theories and behavioral theories.

Olsen at the end of the article explains that change is necessary in traditional financial models and themes and as human behavior does not tend to correct itself, external factors have to be implemented in order to change human behavior so rational decisions can be made. He suggests that peer reviews and journals are an excellent way to convey information to audience especially to individuals who are just starting their careers in finance (Olsen, 2008).

Olsen argues that cognitive dissonance causes problems or behavioral finance in decision making as most of the practitioners apply traditional theories of finance based on their personal belief and perceptions. He suggests that this practice needs to be changed and more emphasis should be placed on behavioral finance rather than traditional theories. This argument though seems logical but research has shown that managers who relied on traditional theories in decision making outperformed markets by a much larger percentage than managers who based their decisions on flexible theories (Faugere, Shawky, & Smith, 2004).

Critical Analysis of Article

There are several ideas and theories presented in the article which may be helpful in some cases but quite confusing in others.. The article as a whole effectively explains the problem of cognitive dissonance in behavioral finance but is also weak in presenting some arguments. The article correctly presents that people perceive themselves positively and identify themselves to be intelligent, moral and competent and this perception limits the ability to reduce dissonance.

The writer presents a notion that people tend to resist changes especially which threaten their personal beliefs and in doing so these people engage in confirmation bias. This is generally true but recent research on change management and the increased benefits of change have substantially decreased the level of resistance and people as managers working in organizations evaluate contradictory ideas in an unbiased manner. The thought that it is difficult to work outside a specific established paradigm in researches carried out in universities and laboratories is quite accurate.

The professors and scientists who supervise researches advise students to strictly follow research methodologies and avoid deviation from prescribed guidelines and principles. The supervisors are so strict that even the slightest change in methodologies may result in heavy grade penalties which force the researcher to carryout research in a close and controlled framework with little room for experimentation. The write suggests that theories of behavioral finance are heavily criticized by traditionalists who fear that people may start thinking of finance as being scientifically feeble.

The traditional models of financial decision making are criticized in the article which is quite relevant as decisions are not merely based on traditional themes and models and a great deal of human behavior is involved in these decisions as well. According to the article decision making in behavioral finance is based on two processes one of which is rational decision making based on past experiences, studies and research. Although rational decision making is a part of behavioral finance but people tend to make irrational decisions due to biasness and other factors such as market trends and overreaction (Olsen, 2008).

Conclusion

The article analyzed here explains how cognitive dissonance creates a problem for behavioral finance. The author presents his views by comparing the traditional and behavioral theories of finance. He suggests that since people are reluctant to change their current beliefs they do not put in much effort to reduce cognitive dissonance in cases where behavior patterns are challenged.

Olsen highlights many flaws which are present in the traditional finance theories through an analysis of several traditional models and themes. Several advantages of applying behavioral finance models in place of traditional theories have been outlined in the article. The author concludes with an implication that problems arising out of cognitive dissonance in behavioral finance have to be resolved by implementing corrections through external instruments such as peer reviewed articles.

Reference List

Cooper, J. (2007). Cognitive dissonance: fifty years of a classic theory. London: Sage.

Faugere, C., Shawky, H. A., & Smith, D. M. (2004). Sell Discipline and Institutional Money Management. The Journal of Portfolio Management , 95-105.

Kuan, H. H., Bock, G. W., & Lee, J. (2007). A cognitive dissonance perspective of customers’ online trust in multi-channel retailers. London: London School of Economics.

Olsen, R. A. (2008). Cognitive Dissonance: The Problem Facing Behavioral Finance. The Journal of Behavioral Finance , 1-4.

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PsychologyWriting. (2022, February 5). Cognitive Dissonance and Behavioral Finance. Retrieved from https://psychologywriting.com/cognitive-dissonance-and-behavioral-finance/

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PsychologyWriting. (2022, February 5). Cognitive Dissonance and Behavioral Finance. https://psychologywriting.com/cognitive-dissonance-and-behavioral-finance/

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"Cognitive Dissonance and Behavioral Finance." PsychologyWriting, 5 Feb. 2022, psychologywriting.com/cognitive-dissonance-and-behavioral-finance/.

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PsychologyWriting. (2022) 'Cognitive Dissonance and Behavioral Finance'. 5 February.

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PsychologyWriting. 2022. "Cognitive Dissonance and Behavioral Finance." February 5, 2022. https://psychologywriting.com/cognitive-dissonance-and-behavioral-finance/.

1. PsychologyWriting. "Cognitive Dissonance and Behavioral Finance." February 5, 2022. https://psychologywriting.com/cognitive-dissonance-and-behavioral-finance/.


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PsychologyWriting. "Cognitive Dissonance and Behavioral Finance." February 5, 2022. https://psychologywriting.com/cognitive-dissonance-and-behavioral-finance/.