to analyze the world in a particular way, and they sell their advice based
on finding supporting—not contradictory—evidence.^17
Recall the failure of analysts in 2000 to change their earnings fore-
casts for the technology sector despite the news that suggested that
something was seriously wrong with their view of the whole industry.
After being fed an upbeat outlook by corporations for many years, ana-
lysts had no idea how to interpret the downbeat news, so most just ig-
nored it.
The propensity to shut out bad news was even more pronounced
among analysts in the Internet sector. Many were so convinced that
these stocks were the wave of the future that, despite the flood of ghastly
news, many downgraded these stocks only afterthey had fallen 80 or 90
percent!
The predisposition to disregard news that does not correspond to
one’s worldview is called cognitive dissonance. Cognitive dissonance is
the discomfort we encounter when we confront evidence that conflicts
with our view or suggests that our abilities or actions are not as a good
as we thought. We all display a natural tendency to minimize this dis-
comfort, which makes it difficult for us to recognize our overconfidence.
Prospect Theory, Loss Aversion, and Holding On to Losing Trades
Dave:I see. Can we talk about individual stocks? Why do I end up hold-
ing so many losers in my portfolio?
IC:Remember I said before that Kahneman and Tversky had kicked off
behavioral finance with prospect theory? A key point in their theory was
that individuals form a reference pointfrom which they judge their per-
formance. They found that from that reference point individuals are
much more upset about losing a given amount of money than they are
from gaining the same amount. They called this behavior loss aversion,
and they suggested that the decision to hold or sell an investment will be
dramatically influenced by whether your stock has gone up or down—
in other words, whether you have had a gain or loss.
Dave:One step at a time. What is this “reference point” you talk about?
IC:Let me ask you a question. When you buy a stock, how do you track
its performance?
Dave:I calculate how much the stock has gone up or down since I
bought it.
328 PART 4 Stock Fluctuations in the Short Run
(^17) David Dreman, Contrarian Investment Strategies.