In modern psychology, cognitive dissonance is the feeling of discomfort when simultaneously holding two or more conflicting cognitions: ideas, beliefs, values or emotional reactions. In a state of dissonance, people may sometimes feel “disequilibrium”: frustration, hunger, dread, guilt, anger, embarrassment, anxiety, etc.
Now how about these headlines appearing today on popular financial news sites:
Cyprus is euro zone’s very own Lehman moment
Buy ‘Still Cheap’ US Stocks, Ignore Cyprus: Pro
If that doesn’t create dissonance I don’t know what will. From “The Psychology of Investing” by John Nofsinger
Investors seek to reduce psychological pain by adjusting their beliefs about the success of past investment choices. For example, at one point in time, an investor will make a decision to purchase a mutual fund. Over time, performance information about the fund will either validate or put into question the wisdom of picking that mutual fund. To reduce cognitive dissonance, the investor’s brain will filter out or reduce the negative information and fixate on the positive information….
I bring this up because depending on what market valuation tools an investor could argue that today’s stock market is undervalued (Fed Model) or overvalued (Shiller PE10). Likely depending on your “ideas, beliefs, values” you are likely to focus on one or the other. From John Hussman and his weekly note sums it up:
“No market condition is permanent, and even the late-1990’s advance included periods where favorable trend-following measures were not joined by hostile syndromes of overbought, overbullish conditions. If you believe that stocks will continue to advance in the months and years ahead, with no intervening bear market decline, those instances are the main points where “don’t fight the trend” might outweigh negative return/risk considerations more generally. For longer-term investors, consider the prospective return you can expect to achieve over time if you are buying, and that you can expect to forego if you are selling. Compare this with your tolerance for volatility, missed short-term returns, and deep interim losses. All of this is what I know and believe. It’s fine to believe something else. But please – insist on supporting evidence and long-term data. The Tinker Bell approach just won’t cut it.“
And that Tinker Bell approach is created in my opinion by the cognitive dissonance just discussed. How you consider Cyprus might be telling of your own view? I focus on Shiller PE10 and believe this is the most pragmatic way to approach investing given that the business cycle exists and there will always be ups and downs. I believe Cyprus is a risk but it hasn’t changed my investment strategy nor should it change yours. Your strategy should be able to coexist with such issues otherwise investment returns will likely be negatively impacted.