Cognitive Distortions of Bear Markets
The grapes of disappointment are always sour.
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Good morning, this is Thinking Capital. A weekly mission for you to optimize your financial life. Today’s mission: cognitive dissonance awareness.
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Good morning,
I spent the last week in West Palm Beach at the Permissionless conference. It being a crypto conference and past two weeks being particularly bumpy for crypto hodlers, I expected a more somber reception. Instead, I was greeted with abundance ($40M yacht parties), excitement (standing room only) and a refreshingly optimistic outlook for the years ahead.
So what was the difference between the mainstream news of markets tanking, and the energy that was shared amongst 7,000+ of us in Palm Beach? A cynic can blame either side:
Mainstream is focused on the news of the day
Or those attending are creating an echo-chamber of optimism
Regardless, both can agree that during turbulent markets, there’s more room for cognitive biases. Said another way, volatility of emotion correlates with volatility in price. So how do we avoid these distortions and keep our mindset focused on the long term?
Let’s start with defining cognitive dissonance, the perception of contradictory information.
When two actions or ideas are not psychologically consistent with each other, people do all in their power to change them until they become consistent. The discomfort is triggered by the person's belief clashing with new information perceived, wherein the individual tries to find a way to resolve the contradiction to reduce their discomfort. (Wikipedia)
In Aesop’s fable, the fox desires the grapes until he realizes that they are out of his reach. Rationalizing his disappointment in himself with a soothing blanket of cognitive dissonance.
We all start with plans, goals, and desires. Things we want to do, see, participate in, etc. The best of which usually being the most difficult to obtain. Think about the last time you set out to do something, but rationalized yourself out of trying because you thought you might fail. Rationalization is just one form of cognitive dissonance to be aware of. Let’s talk about three applications in personal finance:
Rationalization - Just like the fox, we may set out to accomplish something difficult like paying off our debt, only to give up when we realize that it’s an arduous task requiring more sacrifice than we were prepared for. To justify our capitulation, we may tell ourself that being debt-free isn’t what we really want, instead we want to live our “best life” everyday or “treat ourselves” because life is short.
Recency Bias - As I mentioned earlier, volatility in prices can correlate with emotional volatility. If your retirement savings is locked away in an S&P 500 index fund and that fund is tanking before your eyes, it may be tempting to exit the position. The problem is that you’ve already learned that timing the market requires you to be right at least twice; knowing when to sell and knowing when to buy back in again. So it’s best to stay put, and remind yourself that slow and steady wins the race.
All or Nothing Mentality - Similar to recency bias, you may want to take it to the extreme and exit all positions. While you should sell if you absolutely need to free up funds or no longer hold longterm conviction in an asset, you need to ask yourself if that change in conviction is due to the price dip or if it’s due to new information. You may want to remind yourself of market myths.
Ultimately, no one knows what’s in store for the next few weeks, months, years, but if you can avoid cognitive dissonance and keep a long term mindset, you’ll maintain the satisfaction of knowing that you stuck to your plan.
<3
Armand
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