ANZ Finance blog | Super Fund Performance | McGraw Hill Australia New Zealand

If My Super Fund Performed Poorly, I’d Change… But I Don’t Remember It Performing Poorly

Published 29 May 2020

By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland

If My Super Fund Performed Poorly -- McGraw Hill ANZ Finance Blog -- Australia and New Zealand

There’s a concept from psychology called cognitive dissonance. In his 1957 book, A Theory of Cognitive Dissonance, Leon Festinger argued that people experience discomfort when they hold beliefs that contradict each other. To remove this discomfort, people can perform some amazing mental gymnastics. Twisting and turning until consistency is restored.

A good example is contained in a study by Judson Mills (a student of Festinger’s) undertaken in 1958. Among other things, Mills asked students for their opinion on cheating. The opinions were strongly negative. But then, amazingly, Mills found that when those same students were induced to engage in some dishonest academic behaviour they altered their opinions about the immorality of cheating. Likewise, people see what they want to see, adjusting meaning or selectively interpreting information such that it accords with their views in order to avoid dissonance. Oh thank goodness! I thought for a moment my favourite political position was wrong. Luckily this study (which actually says the opposite) says I am totally correct!

In finance, there is ample room for cognitive dissonance. People make lots of decisions. Those decisions and the way they were made give rise to situations where an investor might have to admit error or admit that he is not as clever as he thought or… make a mental adjustment to avoid the uncomfortable feeling of dissonance.

One puzzling type of investor behaviour that troubled financial economists is the habit that investors have of remaining with underperforming managed funds for too long. It’s not as if investors ignore performance. Money does flow out of underperforming managed funds (see Richard Ippolito’s 1992 paper: Consumer Reaction to Measures of Poor Quality). It flows out of underperforming funds, though, at a slower rate than it flows into high performing funds. Investors linger in underperforming funds longer than they should. While there are lots of factors that might contribute to this, Goetzmann & Peles (1997) found some compelling evidence to suggest that cognitive dissonance might play an important role.

In their paper, Cognitive Dissonance and Mutual Fund Investors, they asked investors to state a benchmark for poor performance and to state how long they would stay with an underperforming fund that failed to meet that benchmark. The investors gave their answers. They would dump a bad fund after 2 years. When asked to explain why they had held bad funds for longer than this, the investors remembered the performance of their funds differently. Not only did they remember higher average returns than the funds actually generated, they remembered the fund outperforming their stated benchmark by even more!

Main point: investors feel dissonance at having made a wrong decision (either buying into a bad fund or staying with a once-good fund after performance turned south). To remove this dissonance, they don’t admit their mistakes and try to form a better strategy. Rather, they remember the performance of the funds differently. They change their memory of fund performance rather than confront the negative feelings stemming from a bad decision. Remember, it is not just the bad feeling of having lost money or having missed an opportunity. It is a bad feeling stemming from a contradiction between an investor’s view of themselves and the reality of the situation. People can change their view of reality so that the contradiction disappears!

Discussion Question

What are the implications of cognitive dissonance for the value of information (fund rankings etc.) about superannuation funds? Government regulations are designed to deliver accurate information. But what happens if investors ignore it or twist it around to suit their own beliefs?

Further Reading

Investor decision-making and behaviour is discussed in Chapters 6 and 7 of Financial Institutions, Instruments and Markets 9e. In Chapter 7, a brief introduction to behavioural finance is presented. Behavioural finance has emerged as the types of findings we have talked about here have accumulated over time.