Killer Biases: How 'Cognitive Dissonance' Devastates Trading & Investment Performance.

Cognitive Dissonance is a Human Behavioural Bias which can distort our thinking and perception in ways which can be highly detrimental to the performance of individuals and groups. This article highlights how this can have serious impacts on the performance of traders and investment professionals. However the lessons from this are applicable well beyond the world of finance.

Dennis Gartman states that ‘Capital comes in two varieties, mental and that which is in your pocket, and that of the two 'mental' is the most important and most expensive’. Mental capital is so difficult to control and manage because our minds do not work in the way we like to think they do. In a perfect scenario, they would work to make rational and sound decisions, with pros and cons perfectly weighed up, and outcomes considered objectively. However, reality is very different: Markets are volatile and uncertain, which restricts our ability to act rationally, and our minds are easily swayed by factors which heavily influence the way we think, decide and act. The field of behavioural finance looks to provide greater understanding of how these factors impact our decision making, affects our actions, and shapes our behaviours. A major area of interest for Behavioural Finance is human biases, one of the most impactful of these biases is 'Cognitive Dissonance', a term which is best summed up as how we cope when faced with 'Inconvenient truths'.

People will go to great lengths to avoid admitting an inconvenient truth.

As humans we seek rational explanations based on reason. We seek clarity, certainty, and logical solutions to difficult problems. This mindset is extremely challenged however in financial markets. Whilst there is an order to financial markets, this order is typically only discernible retrospectively. Financial markets are an example of a 'complex system': Complex systems are characterized by high uncertainty, volatility and non-constant variables. In a complex system, cause and effect are only clear with the benefit of hindsight. Contrast this to a 'complicated' system which is more static, and where sensing and analysis makes it possible to discern and find definitive solutions, often with application of scientific principles. Most people have been conditioned to work in 'complicated system', we have been primed this way by our education system and culture. However, the approach for a ‘complicated system', often falls short when faced with the uncertainty of financial markets. The diagram below emphasises this point:



It is within this 'complex' world of trading and investment, where people are seeking certainty and logical solutions, that mental biases can easily distort thinking and perceptions. 'Cognitive Dissonance’ is one of the most pernicious of these biases, and can have deadly consequences for performance in ways which impact short-term thinking and long-term behaviour.

Cognitive Dissonance occurs when we find ourselves compromised by an 'inconvenient truth'. I.e. The market maybe going lower, but we continue to believe in a bullish case long after the bullish case was proved wrong. Sharing opposing beliefs at the same time is mentally troubling and make us feel extremely uncomfortable. When faced with these opposing beliefs in our mind, we may create far-reaching justifications and rationalisations in order to avoid the discomfort connected to ‘Cognitive Dissonance’. Typically, we come down on the side of our initial or invested belief, only changing sides, if at all, when there is overwhelming evidence against us. Think of the classic trading mistake of refusing to cut-out a short-term trade, which then becomes a long-term trade. You didn’t start with a strong long-term conviction, but the short-term trade went horribly wrong and you decided to hold it. You are now faced with two opposing beliefs:

Belief 1) No convincing long-term view.

Belief 2) By running this short-term position as a long-term position it should make money.


Action taken to resolve this dissonance: The right thing would have been to cut the short position and take a loss. But your 'loss aversion’ bias has caused you to avoid that action. Now with these two opposing beliefs you seek resolution of the dissonance. You do this by finding justification in calling this a long-term trade. This post-hoc rationalization is probably no better than tossing a coin, and often worse, as the market is already against you. These rationalisations now cause your perception to become more skewed. You start seeking news you want to see and ignoring the news you don’t. ‘Confirmation bias' now distorts your perception further. The path to losing more money than you ever anticipated on this trade is set. - Even worse, and possibly more damaging for your future, is the possibility this works out well!!! For now you will repeat this behaviour, and may even become part of the way you work. However, this behaviour is in direct opposition to every bit of sound trading advice (See Dennis Gartmans rules of trading). Over time, it will lead to more large losses than your account can handle. - This all came around because you could not face the inconvenient truth 'that you were wrong'. The irony being, that 'being  wrong' is just part of life in a complex world of high uncertainty.

Cognitive dissonance seriously impacts performance in more ways than you realise.

One of my coaching clients provided an excellent recent example of the damage ‘Cognitive Dissonance’ can reap. At the start of this year he turned bearish on stocks. He bought puts in the SP500, and also sold the DAX heavily. Within a few days he looked as if he was on the way to some decent profits. However, the market turned sharply, and went on a long bullish run, the trader however continued to fight this bullish move and his early year gains soon gave way to early year losses. It was now that his 'Cognitive Dissonance' started to come into play, his bearish view was maintained even as the market clearly showed bullish short-term sentiment. To add to the pain, two of his colleagues defected to the bull-side. He was now scampering around trying to find justifications for why he maintained the short trade. These justifications slowly become more desperate, he recalled himself thinking and saying that he was 'more convinced than ever that the market is wrong'. - All the time, in the cruel world that is trading, his losses were growing. Eventually the pain got too much and he pulled the plug on the short trade. - This is what 'Cognitive Dissonance' does, it can divorce one from reality, and force them to start defending their ego and pride at the cost of objectivity. -
No one is immune from getting caught in this sort of trap, this trader was no novice but a senior 'Portfolio manager' at a major hedge fund. To his credit, he recognized this afterwards and when we discussed it in a coaching session he was able to exorcise the ghost of this trade from his psyche.

Whilst this highlights how Cognitive Dissonance impacts trading performance directly, there is a far more devastating indirect element to 'Cognitive Dissonance' which can cause irrevocable long-term harm: Cognitive Dissonance can stop people from learning, and keep them in a 'closed loop' which leads to habitual repetition of mistakes and errors. This can become all the more insidious the more mature one gets. During a trader’s formative years, they are likely to have managers and mentors who point out their faults. However, as traders mature, they are less likely to get this feedback and support. Without this third party perspective, it can become incredibly difficult for people to recognize when they face a 'Cognitive Dissonance', let alone to resolve it in a balanced and objective way. In the above example, the Hedge Fund Portfolio Manager recalled a number of occasions over the years, where he has been stubborn and obstinate in the face of overwhelming evidence that he was wrong. I can also reflect on my own trading within my 25-year career trading FX and rates. There was a dark time in the mid-1990s where I kind of lost my way. I recall a number of similar trading experiences to the example above, perhaps it was not a surprise that my confidence suffered for a couple of years after those experiences.


Cognitive Dissonance Can Kill Your Performance and Potentially Your Career.

The term 'Killer Biases' may sound a catchy title for an article which gets people's attention, however certain biases can literally kill a career, a company (Kodak), and even people. 'The Semmelweis Reflex' is a term which describes the tendency to reject new evidence or new knowledge because it contradicts established beliefs. It was coined after the story of Ignaz Semmelweis, a Hungarian Doctor working in the Vienna General Hospital in the 19th Century. Semmelweis found that mortality rates of women giving birth dropped ten-fold when doctors washed their hands with a chlorine solution between patients and after autopsies. He tried to spread word of his discovery throughout the European medical profession, however his advice was rejected by fellow doctors who refused to believe that their own negligence may have something to do with the death of patients in their care. As a result many thousands of women continued to die needlessly for many years to come. Carol Tavris, and Elliot Aronson, cover this topic far more broadly in a brilliant book, 'Mistakes were Made (but not by me)'
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Developing superior 'Cognitive Skills and 'Better Behavioural Practices' is the antidote!

It is incredibly difficult to know when you are in a situation where ‘Cognitive dissonance’ is occurring. Daniel Kahneman calls it correctly when he says “We're blind to our blindness. We have very little idea of how little we know. We're not designed to.”

The best way to avoid ‘Cognitive dissonance’ is to preempt it by developing better behavioural practices. This may not stop every single occurrence of c
ognitive dissonance, but it can certainly reduce, limit and mitigate the damage. In my recent article, 'The 10 Major Behavioural Traits of Highly Successful Traders ', trait number 5 emphasized 'Humility and Humbleness': Humble traders are less likely to fall victim to their ‘Ego’, and thus less likely to be seriously impacted by ‘Cognitive Dissonance’.
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Beyond the Hype: The 10 Behavioural Traits of Highly Successful Traders.

Click here to view
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Everyone is capable of displaying 'Cognitive Dissonance', it is part of our human operating system, however certain people are able to manage or avoid it far better than others. These people are 'Behavioural Masters'. Behavioural Mastery is vital for successful trading, probably more so than any system, product, analytical tool or service, yet is so undervalued in terms of people's priorities. People may think the likes of Warren Buffet, Paul Tudor-Jones, Ray Dalio, have some super source of informational advantage, however every bit of information they get is available to the rest of the world. The difference is that these people are 'Behavioural Masters', they execute everything that they do a little better and a little smarter. As such they create a behavioural edge. Buffet has his long-term philosophy built around his own specific temperament. Paul Tudor Jones perfected the art of strict discipline and Money Management. Whilst Ray Dalio built his business around his key core principles. 


Our own work at Alpha R Cubed has demonstrated how developing people’s cognitive and behavioural abilities can make a huge difference to their performance. Our coaching and consulting helps people and teams to leverage their behavioural strengths and develop superior cognition to improve how they engage with risk and monetise the uncertainty within financial markets. The table below highlights some examples of how this can help make a huge difference to performance. These are just some examples from bank and hedge fund clients where performance improvements have contributed to multi-million dollar improvements in performance.



These numbers only tell part of the story, client feedback tells another. The following is a from Simon Horwood, formerly Co-Head of Trading for Global FX and Short-Term Rates at Credit Suisse. It is part of a response to an internal inquiry about the coaching's effectiveness: 

"Why I feel this has been successful, are the performances of traders that have been under the programmes tutelage. Now obviously improved market conditions have played a part, as well as luck etc. But one trader who has refused to take part in the 'coaching' has turned out to be the lowest revenue producer for the past two years having been consistently the highest for the previous five. Also, all the individuals that have taken part have become easier to manage, show greater teamwork and just appear to be happier overall. The positive impact on the group has been profound."


Wrap Up.

Cognitive Dissonance doesn’t just affect individuals, it comes to affect teams, group, companies even whole industries and professions even. It is a pernicious bias which operates largely ‘under the radar’ and beyond ‘consciousness’ within our human operating system. Only by developing superior thinking and behavioural skills, and reflective processes, will one be able to reduce the damaging and affect this can have on performance and outcomes.
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Steven Goldstein is a leading Performance and Executive Coach working with Traders, Banks, Energy Firms and Hedge funds: He is Managing Director of at Alpha R Cubed, which works with banks and investment firms to improve their human capital within financial risk businesses. To know more about Alpha R Cubed, visit their website www.alpharcubed.com or email Steven at steven.goldstein@alpharcubed.com.

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