The purpose of this essay is to explain what is the theory of cognitive dissonance, what processes does it explain and how it is practically used in modern economy.
The theory of cognitive dissonance which was firstly presented by Leon Festinger in 1957 is receiving renewed attention today, as a lot of researchers use it as one of the most important theories, which helps to model behavior of the economic agents (consumers or investors) in situations directly related to financial decision-making. What is more, this theory is one of the main theories in behavioral finance; the science, which uses psychologically-based theories and mechanisms to model investors behavior in financial markets.
One of the main contradictions in modern financial economy is between the classical financial theory (or Efficient Market Hypothesis) and behavioral. According to the efficient market hypothesis the security (or stock) prices already reflect all the available information, including the view that each buyer and seller in financial markets behaves truly rationally, motivated by self-interest. However, this theory fails to consider that peoples irrationality can influence their decisions, while behavioral economic theories predict, that sometimes people’s emotions and beliefs will prevail, leading most of them to make incorrect decisions. Especially, when we are talking, for example, about making investment decisions (see Scientific American july 2009). The theories, especially the cognitive dissonance, were broadly used by economists to describe the reasons why the recent financial crisis happened, that is why this theory is important nowadays.
Cognitive dissonance is the judgmental bias, that people tend to make, because they don’t want to admit that they are wrong. It is usually painful to realize that the thing that someone has really believed in is wrong. Thereby, people always try to find evidences to support their beliefs. Cognitive dissonance is the discomfort people usually feel when they take action that conflicts their typically positive self-image. Then next thing people do is try to remove that feeling of discomfort: they manipulate their beliefs. We can use smokers as an example. A smoker could ask himself, why is he or she doing this, because it is bad for the health. So, in order to remove this dissonance, because it is usually hard to just stop smoking, he manipulates his beliefs and persuades himself, that smoking is not as risky as some say.
Cognitive dissonance is usually associated with the belief manipulation hypothesis. From the belief manipulation view, people are often unaware of risk they taking. The belief manipulation view tries to explain exactly, why they are unaware. Shortly, they are unaware, because they choose to be (see Nicholas Barberis 2011). The same thing happened even with such a big credit agencies like Moody’s or Standard and Poors, before the recent financial crisis (2007-2008). The problem is that those credit agencies were providing AAA ratings (credit ratings used by investment professionals to assess the likelihood that debt will be repaid) to so called subprime-linked securities (a subprime-linked security is a security, which is based on real estate and as it is know the crisis had started from real estate market, therefore it was a risky asset). The main idea here is that the analyst at a rating agency was asked, by an issuing bank, to give a AAA rating, had a strong financial incentive to do so, even if the rating seemed to be undeserved: by rating the product AAA, he would avoid losing the business to another rating agency, thereby allowing both him and his firm to earn more money that quarter. At the same he would always want to create a positive self-image as a responsible and useful person, who is providing a good service for the society. And again there is a strong evidence of cognitive dissonance, so to reduce uncomfortable feelings of dissonance, that he is giving this rating to a security that doesn’t really deserves it, he manipulates his beliefs (see Wilson and Akert 2005). He probably could tell himself, if the house prices were rising all the time before, than they would rise in the future and that leads to another bias, which is also connected with cognitive dissonance: the representativeness heuristics. According to that heuristic people have a natural tendency to believe that past trends will continue into the future, which is quite similar to the over-extrapolation. The phenomena that people, when achieving some profits tend to think that it will be all the time like that, so they overestimate their own forecasts.
To draw a conclusion, the theories of behavioral finance are broadly used by researchers to describe the financial processes, happening in financial markets, which are quiet hard to describe. The theory of cognitive dissonance, as it is proved in the essay, plays its role in the financial world. Finally, it would be appropriate to conclude with the words of Robert J. Schiller, a professor of economics at Yale University: “Denying the importance of psychology and other social sciences for financial theory would be analogous to physicists denying the importance of friction in the application of Newtonian mechanics” (see R. J. Schiller (2008).
1) Scientific American (July 2009) page 78-85.
2) Barberis N. (2011). Psychology and financial crisis 2007-2008. Yale School of Managenent.
3) Aronson, E., Wilson, T., and R. Akert (2005), Social Psychology, Prentice Hall, Fifth Edition.
4) Schiller, R. J. (2008). Subprime solution: How Todays Global Financial Crisis Happened and What to Do about it. Princeton University Press, p. 92.