Tag Archives: greater fool theory

Cognitive dissonance and the impact it has on investing

21 Apr

You know when you invest in a stock and then you try to seek out every reason to validate your investment thesis i.e. ‘this stock is cheap, look how much cash they have on their balance sheet, its year-on-year growth momentum will ensure the company grows into its earnings multiple’ etc; and you phase out almost all negative information about the stock (which may just be the plain reality), well scientists (well not the ones in white lab coats!), have a term for this collective pattern of behaviours, ‘cognitive dissonance’.

A large part of investing is about psychology and sentiment and what drives human behaviour. Cognitive dissonance is perhaps one of the most significant psychological theories with a direct transmission mechanism into investing.  Investors purchase stocks long or short because they hold a certain set of beliefs about that stock, even short term investors.  Now if markets are efficient information is already in the market and prices should adjust accordingly. Now, unless everyone is trading on inside information they
are taking positions based on their interpretation of market information. It is precisely this fact which essentially makes markets.

Cognitive dissonance almost explains why investors typically nurse significant losses on stocks and don’t always sell them even when they have ample opportunities to exit positions incurring only marginal losses.  When bad news occurs, damaging fundamentals, the idea of buying into weakness or lowering your average purchase price reinforces this cognitive dissonance behaviour. Instead we should be reconsidering the position itself.

A good example of effectively managing cognitive dissonance behaviour was Whitney Tilson’s  Netflix short. Clearly on a financial metric basis the company is overvalued and faces a number of headwinds going forwards. In addition, negative news or general downward market momentum is likely to result in Netflix experiencing deeper stock price losses due to the significant appreciation which has already been achieved to date. However, the company is the premier franchise in online video; international expansion also offers the opportunity to further consolidate their dominant positioning. It would also cost competitors billions to create a bold infrastructure to compete.

Netflix also has first mover advantages and although content costs are high and are expected to increase this is somewhat offset by subscriber growth, and the potential to leverage subscriber price increases. Also any upward guidance is likely to propel the stock artificially higher due to the existing high short interest.

Whitney covered his short and this prevented potential further losses of approx 50%+. He appreciated that his position was not as originally perceived; but there are shorts who have been in Netflix since $70 and the stock has had a parabolic move since then. It is this behaviour of ignoring company and market fundamentals that reflects exactly what cognitive dissonance is. So the next time you see a psychology or social studies book, don’t throw it by the way-side, as it may just contain that small nugget of wisdom hidden behind all that bravado.

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