Research Insights: Cognitive Dissonance in investor decision-making

It is well established that investors sometimes ignore pertinent information when making decisions about trading stocks. This phenomenon has most often been pinned to bounded rationality, that is, limitations on individuals’ reasoning—for example, due to time constraints or cognitive capabilities. But new research finds that a cause may be cognitive dissonance, the state of holding inconsistent or conflicting thoughts when faced with a behavioral decision.

Zhijian Huang, Associate Professor in Saunders College Department of Finance and Accounting, co-authored an article, “Asymmetric response to earnings news across different sentiment states: The role of cognitive dissonance,” published in the Journal of Corporate Finance. Huang and his collaborators tested a hypothesis that earnings announcements contradictory to current market sentiment trigger cognitive dissonance, causing investors to disregard bad news when they are optimistic about the market, and good news when they are pessimistic.

The researchers first constructed a sentiment index—showing when investors are optimistic or pessimistic—for the Chinese stock market over the years 2008 to 2019. Then they measured stock price sensitivity to earnings surprises over a three-day window in positive or negative investor sentiment states.

Their principal finding: investors tend to ignore information that does not conform to their current sentiment. When the market-wide sentiment is optimistic, stock prices promptly react to positive earnings surprises but not to negative ones. Conversely, when sentiment is pessimistic, only negative earnings surprises are quickly reflected in prices. That is, cognitive dissonance could explain investors’ underuse of accounting information when making investment decisions.

Intriguingly, Huang and his co-authors also found that the effect of cognitive dissonance varies depending on investor sentiment. Specifically, cognitive dissonance causes a temporary muted response to bad news when sentiment is optimistic, but a persistent muted response to good news when it is pessimistic.

View paper in the Journal of Corporate Finance (February 2023), Asymmetric response to earnings news across different sentiment states: The role of cognitive dissonance.