Cognitive dissonance is defined as an inconsistency among some experiences, beliefs, attitudes, or feelings. And according to psychological theory, this dissonance creates a rather unpleasant state that people try to minimize by reinterpreting some or all of their beliefs so that they are consistent with the others. Researchers (Akerlof and Dickens*) have gone a little further than this and suggested a three-fold proposition: (1) people have specific preferences over their beliefs and attitudes – for example they want to believe they are kind or thoughtful, that their decisions are insightful, or that the conclusions are sound, (2) people can partially control their beliefs – for example they choose to pay attention to information that is likely to provide support for existing beliefs that they prefer, and (3) once a person chooses his or her beliefs, those beliefs are sticky – people generally do not want to change their beliefs.

Indeed, psychological experiments have yielded fruitful insights into these very statements. For example, studies have shown that race track bettors place much higher odds on their horse after they have made the bet than beforehand; as well, studies have shown that women choosing to purchase home appliances regularly and systematically change their evaluations of those purchases to be consistent with the appliance that they choose.

So what does this have to do with markets? Cognitive dissonance is precisely the mechanism underlying investor’s beliefs about causal relationships in financial markets. You know, those old Wall Street aphorisms that ‘everybody knows’ are true: that the Fed controls interest rates (they don’t, they follow the bond market’s lead), that low interest rates are good for stocks (try telling that to the Japanese), that gold is a hedge against inflation (M3 up 600+% in the last 20 years and gold is down), and our favorite because it is so easily disproved, that oil prices and stock prices are inversely correlated on any time frame.

When presented with facts that show that any of the above statements are false, most investors who accept those causal relationships as fact immediately enter a state of cognitive dissonance because of #1 and #3 above: they want to believe that they are insightful and thus that their conclusions and beliefs are correct, thus making those beliefs sticky. They try to minimize the dissonance by focusing on information that provides support for their view (#2 above). Researchers have found that actually changing ones belief system comes down to a cost/benefit equation that is highly personal: is the cognitive cost of changing your beliefs higher than the cost of not changing it. Stated another way: is the benefit of keeping your beliefs higher than the benefit derived from changing them.

For Fed watchers at various buy-side, sell-side, and consultancy firms, changing their beliefs that the Fed does not actually control interest rates has very high costs indeed. After all, their very livelihood – their ability to feed themselves – rests on their acceptance of this falsity. So in the case of Fed watchers, one could make the strong case that the cognitive dissonance costs of changing their beliefs are much higher than keeping them. And that is why they refuse to see – despite very clear evidence – that the Fed does not control interest rates. We could make the same case for the other causal relationship beliefs: oil vs. stocks, interest rates and stocks, gold and inflation, etc.

I always found it remarkable – indeed frustrating – that when presented with perfectly reasonable and factual evidence to the contrary, investors still would not let go of their (false) beliefs. Understanding cognitive dissonance theory has helped me to see why some people will simply always believe the world is flat.

*See Akerlof, G. A., and W. T. Dickens. "The economic consequences of cognitive dissonance." American Economic Review 72 (3): 307–319 (1982).