Cognitive Dissonance Theory:
A conflict arises after nearly all decisions involving a choice between alternatives. This is because
the chosen alternative often has negative aspects, and the rejected alternative also has positive characteristics. The characteristics contradict the opinion of the decision maker, who is convinced
she has made the best possible choice. Such a contradiction is known as “cognitive dissonance”.
A particular commitment is prerequisite for the creation of dissonance. Commitment occurs when
we have an emotional attachment to a decision. Most people try to avoid dissonant situations, and
they will try to even ignore information that might increase their discomfort. There are two ways of achieving that:
SELECTIVE PERCEPTION: people observe mainly information, which favors of the decision made. Thus,
information is distorted to meet a need and this might give rise to wrong further decisions.
SELECTIVE DECISION MAKING: people act in such a way that their initial decision, probably accompanied
by high commitment, leads to the desired result, even if they must pay a high price for this. They will continue to invest in a project, hoping that the investment so far has not been for nothing.

How people try to avoid dissonance...
People endeavor not to make wrong decisions in order to avoid regret and disappointment. The results
of
a wrong decision are perceived as more negative than the damage that might be incurred through
doing nothing. This leads people to be passive rather than active, insofar as they are confronted with decision-making situations under certain conditions, and to rely on the old ways instead. People
usually experince loss aversion, that is they feel losses much more deeply than gains of the same
value.

The need to control
Every person has the need to perceive himself as the originator of changes in her environment.
This gives rise to feelings of competence and a sense of one’s own value. There are several forms
of control pertinent to Behavioral Finance Theory:
CONTROL THROUGH PREDICTION: predictions invoke the sense of being able to control the market.
Analysts believe that the more logically predictions have been compiled, the more probable that
they will come true.
CONTROL THROUGH AWARENESS OF THE INFLUENCE FACTOR: a decision maker considers a situation more controllable when she feels that she is fully informed and competent. Such situations, characterized
by full information and clearly indicated and reliable probability, are not typical for the financial smarkets.

Factors of control
The investors who review their performances only after long intervals perceive the smallest control
deficit. Investors, who check daily whether their shares have gained or lost, will perceive the risks as much larger and will realize that they are at the mercy of the markets. The investors who follow price movements act much more risk-averse and on the whole achieve worse results.

Consequences of the need to control
People tend to have too great confidence in their own ability.This is a source of error which distorts perception. The greater the confidence peopel have in themselves, the more risk there is of overconfidence.
+ If people succeed, they believe this to be due solely to personal skills; if something goes wrong,
then others, or adverse circumstances, are to blame.
+ Many people tend to overestimate what they knew or suspected about the outcome of an event
before it took place. This is called “hindsight bias”. Nobody knows exactly whether a price will rise
or fall. However, many people seem to remember that they had a feeling that it would be so.
+ After a loss of control people either call a well-known analyst or seek out a group of people with
similar opinion, e.g. investment club. Comparing opinions in the group creates an illusion of validity.

 

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