Rationalization
Lesson summary:
Motivated reasoning is a psychological process where individuals selectively gather, interpret, and remember information that supports their existing beliefs, while ignoring or downplaying conflicting evidence. This mechanism is used to reduce cognitive dissonance, the discomfort experienced when confronted with two contradictory beliefs or when our actions don’t align with our beliefs.
For instance, consider a person who firmly believes that driving is safer than flying. Despite statistics showing that air travel is statistically safer, they may focus on news stories of plane crashes and ignore the numerous reports of daily road accidents. This selective interpretation and recall of information allows them to maintain their belief that driving is safer.
How Rationalization applies to investing and trading:
In the context of investing and trading, motivated reasoning can be a major pitfall. An investor might, for instance, hold a strong belief that a particular company will be successful. Even when there are clear signs of trouble—like declining sales or an increase in the company’s debt—they might selectively interpret the data to support their existing belief. They may focus on the company’s past successes and ignore the clear indicators of potential failure, therefore not selling their shares and potentially facing financial loss.
For example, an investor might be convinced that a start-up technology company is going to be the next big thing. Even if quarterly financial reports show a pattern of loss, the investor might dismiss this as typical of start-ups, clinging to their belief. They might even double down and buy more shares, convinced that they’ll be rewarded in the end. This showcases the role of motivated reasoning in their investment decisions. However, a more balanced approach that takes all evidence into account would likely lead to better financial outcomes.