Behavioral Finance and Your Portfolio. Michael M. Pompian

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      1 You immediately head to your home office and page through the various consumer magazines to determine whether you should have purchased Model B.

      2 You proceed with washing the car and think, “If I had it to do all over again, I may have purchased Model Z. Even though mine doesn't have a navigation system, I'm still pleased with Model B.”

      3 You contemplate doing some additional research on Model Z. However, you decide not to follow through on the idea. The car was a big, important purchase, and you've been so happy with it—the prospect of discovering an error in your purchase leaves you feeling uneasy. Better to just put this thought to rest and continue to enjoy the car.

      1 modifying beliefs,

      2 modifying actions, and

      3 modifying perceptions of relevant action(s).

      1 Modifying beliefs. Perhaps the easiest way to resolve dissonance between actions and beliefs is simply to alter the relevant beliefs. When the principle in question is important to you, however, such a course of action becomes unlikely. People's most basic beliefs tend to remain stable; they don't just go around modifying their fundamental moral matrices on a day-to-day basis.Investors, however, do sometimes opt for this path of least resistance when attempting to eliminate dissonance (although the belief-modification mechanism is the least common, in finance, of the three coping tactics discussed here). For example, if the behavior in question was “selling a losing investment” that has little chance of recovering one might concoct a rationale along the lines of “it is okay not to sell a losing investment” in order to resolve cognitive dissonance and permit yourself to hold onto a stock. This behavior, obviously, may pose hazards to your wealth. Taking a tax loss and moving on is typically the best course of action in this scenario.

      2 Modifying actions. On realizing that you have engaged in behavior contradictory to some preexisting belief, you might attempt to instill fear and anxiety into your decision in order to averse-condition yourself against committing the same act in the future. However, averse conditioning is often a poor mechanism for learning, especially if you can train yourself, over time, to simply tolerate the distressful consequences associated with a “forbidden” behavior.Investors may successfully leverage averse conditioning. For example, in the instance wherein a losing investment must be sold, an individual could summon such anxiety at the prospect of actually losing money. Again, taking a tax loss and moving on is a good solution. Even the best investors take losses and move on.

      3 Modifying perceptions of relevant action(s). A more difficult approach to reconciling cognitive dissonance is to rationalize whatever action has brought you into conflict with your beliefs. For example, you may decide that while hitting a dog is generally a bad idea, the dog whom you hit was not behaving well; therefore, you haven't done anything wrong. People relying on this technique try to recontextualize whatever action has generated the current state of mental discomfort so that the action no longer appears to be inconsistent with any particular belief.An investor might rationalize retaining a losing investment: “I don't really need the money right now, so I won't sell” is a justification that might resolve cognitive dissonance. This type of rationalization often leads to sub-optimal investment results.

      1 1 James Montier, Behavioural Finance: Insights into Irrational Minds and Markets (West Sussex, England: John Wiley & Sons, 2002).