Cognitive dissonance … the key to playing the market

Cognitive dissonance is the discomfort caused by holding conflicting cognitions (e.g., ideas, beliefs, values, emotional reactions) simultaneously.  An example would be – believing that lying is bad (first cognition) and then being forced to lie (second cognition).  With that in mind, I like this story by William A. Kent from “The Journal of Personality and Social Psychology:”

“At two race tracks interviewers questioned 69 horse players on their way TO the $2 window and 72 others on their way FROM the window.  The interviewers asked all bettors to rate their chances of winning on a scale of 1 to 10.  The result was that the bettors returning from placing their bets had significantly MORE confidence in their choices than those interviewed BEFORE their bets were made.  Thus, bettors facing doubts as to whether they had bet on the right horse relieved their tension by believing even more after the fact that they had done the right thing.”

From a psychology point of view, the aforementioned quote suggests that in order to reduce the anxiety of decision making, people perceive things in ways that may or may not be logical.  Simply stated, people talk the way they bet.  From a stock market perspective this means that the interpretation of economic and market news varies in direct relationship to the investor’s bullish, bearish, or cautious market position.  At the race track if too many participants bet on the same horse, the betting odds on that horse go down.  In other words, if the horse is “heavily bet” he becomes the favorite and therefore even if he wins the payout is small.  Q.E.D., popularity reduces the reward.  Similarly in the stock market if too many participants put their money on the same stock, and it becomes a market favorite, driving the price ever higher, the upside potential is diminished.  Hereto, popularity reduces the potential reward.  Just listen to what Benjamin Graham has to say about this in his book titled “The Intelligent Investor:”

“The intelligent investor realizes that stocks become more risky, not less, as their prices rise – and less risky, not more, as their prices fall.  The intelligent investor dreads a bull market, since it makes stocks more costly to buy.  And conversely (so long as you keep enough cash on hand to meet your spending needs) you should welcome a bear market, since it puts stocks back on sale.”  Graham goes on to note, “The value of any investment is, and always must be, a function of the price you pay for it.”  This is directly opposed to the Jeremy Siegel school of thought that suggests 7%+ per annum returns over the long-term are a “divine right.”  My main point is that “cognitive dissonance,” once recognized, should probably be bet against.  To wit, when everybody bets on the same horse, stock, or market direction, it often pays to go against the crowd.  In our business we call this strategy “contrary opinion” investing.  While Ben Graham states it much more eloquently, we have often referred to this type of strategy as “buying the flop,” except in this case we are not referring to the card game “Texas Hold ‘em,” but as legendary investor Jim Rogers puts it – buy panic and sell euphoria

via Jeffrey Saut

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