In the world of investments, one encounters a myriad of decision-making moments. Each decision carries with it the potential for gains or losses, success or failure. Often, after making these decisions and observing the outcomes, investors tend to rationalize their choices to make them fit with the observed results. This phenomenon is referred to as post-rationalization. In this article, we will delve deep into the concept, providing examples to illustrate its occurrence and offering guidance on how investors can avoid its pitfalls.
What is Post-Rationalization?
Post-rationalization refers to the act of creating a justification for a decision after the outcome has already been observed, rather than basing the decision on logical reasoning from the start. This cognitive bias is akin to the proverbial "hindsight is 20/20," but with a twist: it's not just observing what one could have done but actively justifying the decision made after the fact.
Why Does Post-Rationalization Occur?
Humans are naturally inclined to avoid cognitive dissonance—the discomfort one feels when holding conflicting beliefs or attitudes. When an investment doesn't pan out as expected, it can create dissonance between an investor's belief in their decision-making skills and the reality of their unsuccessful choice. To mitigate this discomfort, an investor might search for reasons that validate their decision, even if those reasons weren't considered initially.
Examples of Post-Rationalization in Investment
Tech Stock Investments: Consider an investor who buys shares in a new tech company based on a friend's recommendation and without much research. If the stock price plummets, the investor might later say, "I invested because I believed in the long-term potential of their technology," even if that wasn't their initial rationale.
Failing to Diversify: An investor puts most of their funds into one sector, let's say, real estate. When a downturn hits that sector hard, they might post-rationalize by stating, "I always thought it was a bubble, but I wanted to take the risk," even though they never voiced or considered such concerns before the downturn.
Selling a Performer Early: An investor sells a stock after a small gain, but then it surges dramatically higher. They might later justify their decision by saying, "I was concerned about its high volatility," even if that wasn't a consideration when they sold.
How Can Investors Counteract Post-Rationalization?
Document Decision Rationale: Before making any investment decision, jot down the reasons for that choice. This creates a clear record to refer to later and can help in analyzing where your decision-making process can improve.
Seek External Input: Talk to trusted peers or advisors about your decisions. External perspectives can often shed light on areas where you might be rationalizing.
Embrace Mistakes: Everyone makes errors in judgment. By accepting that mistakes are a part of the learning process and not attempting to always justify them, you're better positioned to learn and grow as an investor.
Stay Educated: Continuous learning helps in refining the decision-making process. The more you know about market dynamics, investment strategies, and behavioral finance, the better equipped you'll be to recognize and combat cognitive biases.
Review Regularly: Periodically review your portfolio and the reasons behind each holding. By comparing your initial reasons with current performance, you can ascertain if your initial reasons still hold or if you're post-rationalizing.
While post-rationalization is a natural human tendency, it can hinder growth and learning in the investment realm. By being aware of this bias, documenting decisions, seeking external perspectives, embracing mistakes, staying educated, and conducting regular reviews, investors can cultivate a more objective and effective decision-making approach.