Seeking Alpha

Cognitive Dissonance And The Bull Market

by: Kevin Wilson

One of the real hazards to clients’ financial well-being is the career risk that they impose on their advisors; clients are subject to episodes of cognitive dissonance that cause problems.

An example of this occurs when clients insist on taking maximum risk at market tops; this adds a layer of conflict regarding the advisor's fiduciary duty.

Many advisors know from experience that if they act as a fiduciary to protect client assets when risk is extreme, they may be fired for not chasing returns.

Famous investor Jeremy Grantham of GMO experienced this in the run-up to the bursting of the tech bubble, losing a huge amount of assets in the process.

We face less extreme circumstances, but market indicators suggest high risk and unusual market behavior; I would hold AQMNX, QLENX, QMNIX, OTCRX, BXMX, SPLV, USMV, IAU, TLT, BIV, BOND, and TOTL.


One of the real hazards to clients' financial well-being is the career risk that they impose on their advisors. Clients, because they are human, are often afflicted with cognitive dissonance, i.e., "the discomfort experienced by an individual who holds two or more contradictory beliefs, ideas, or values at the same time". When that client is confronted with new information that contradicts one or more beliefs, ideas, or values, problems can arise. The classic example of this is many clients' insistence on taking maximum risk at market tops, and minimum risk at market bottoms. This is clearly irrational behavior, but so common that it is actually the norm. What this does to advisors, who are also subject to cognitive dissonance of their own, is add on a layer of internal conflict caused by the fact that the advisor must act as a fiduciary but will often be fired for doing so. This is something that is intrinsic to human nature, but ultimately can be very destructive of a person's net worth over time.

Famous Investor Jeremy Grantham of GMO


There are some classic stories of how this works at actual market tops. One that is well worth remembering involves famous investor Jeremy Grantham's company, GMO, in the run-up and aftermath of the NASDAQ bubble. Grantham's econometric models suggested that a huge bear market was coming, so in 1998, he pulled back on risk and advised his institutional clients that equity market risk was extremely high and expected returns for the next 10 years were negative. He stayed with that call all the way into the NASDAQ meltdown in 2000 (Chart 1). But the market continued upwards for literally years after his initial call, and he ended up losing about 40% of his assets under management as institutional investors ignored his call and fired his firm for being too cautious. Interestingly, his models were fairly accurate (Chart 2), and those investors who fired GMO almost certainly lost big money in the bear market. Once all these institutional investors got bloodied in the market, they came running back again, and GMO grew rapidly on its reputation for making the right calls. But that was only after these clients took the hit and realized they had been wrong.

Chart 1: GMO's 10-Yr. Forecast in 2000


Chart 2: Actual Performance in Decade After GMO's Call


In the NASDAQ bubble during 1999, there was a narrative about the Internet that led people to believe that "this time is different." Evidence to the contrary was ignored in a kind of mass cognitive dissonance episode that ultimately cost millions of people huge paper losses on their new era technology stocks. And there was absolutely tons of such evidence. For example, the market value/GDP ratio used by Warren Buffett as a valuation tool spiked to the highest reading ever recorded in the history of the markets at least three months before the top (Chart 3). Numerous big name technology companies like WorldCom, Global Crossing, Qualcomm (NASDAQ:QCOM), and Cisco (NASDAQ:CSCO) had P/E ratios of 50-100 (or more) with only marginal earnings and revenue. Many of the most popular IPOs in 1999 had no earnings at all! 16 companies, including "famous" names like, and, purchased 30-second spots for the Super Bowl and paid $2 million each for them. Many are now defunct.

Chart 3: Market Value/GDP Spike in Valuation in 2000


The NASDAQ Composite Index dropped 79% in the bear market from March 2000 to October 2002 (Chart 4). I remember being moderately conservative in final stage of the rally in 1999, advising clients to avoid the most outrageously overpriced technology names; as a result, I received multiple complaints and threats to leave from clients who had "only" made 25% while their neighbors were reportedly making as much as 100% that year. As the old saying goes though, it's not what you make that counts, it's what you keep. Anyway, I had seen an analysis of the market in the fall of 1999 that discussed GMO's predictions and also demonstrated that the market seriously lacked breadth, and that the average stock was actually already in a bear market. So I set up some modestly defensive portfolio allocations and waited for the crash. I lost some clients, some of whom eventually returned a year or two after the crash. I made the choice, you see, to fulfill my fiduciary duty, much like Jeremy Grantham did on a much larger and more public scale, and I tried to accept the lost accounts philosophically.

Chart 4: NASDAQ Composite Collapse 2000-2002


Then, we went through a similar kind of thing with the housing bubble in 2004-2007, when people everywhere were shouting, "They aren't making any more land you know!" Ergo, the price would go to the moon and stay there. Once again, there was much evidence to the contrary, and once again, it was mostly ignored. Prices had little connection to reality when the market peaked in 2006 (Chart 5). I remember sitting in a private bank in a major metropolitan area, during a meeting with eager clients wanting to get in on the land rush in 2004. They wanted to buy three condo units in Naples, Florida with only 3% down. I was called in by the banker in my unit for an opinion from a planner's point of view. I asked quite a few questions and then after some thought, I did my fiduciary duty by telling them not to do the deal.

Chart 5: Housing Bubble Parameters

Source: R. Shiller;

Everybody was mad at me at once. The banker was unhappy instantly, the department head was unhappy after that, and the clients were pretty unhappy as well. What I had done was insist on a point of view that regarded the actual facts of the case in question, and attempted to evaluate the actual risk to the clients (and the bank), rather than giving credence to the collective narrative about how prices were so great that only a fool wouldn't use maximum leverage. Cognitive dissonance kicked into high gear, and I was the bad guy who tried to ruin it all. Unfortunately, the banker was persistent and the clients were greedy, so the deal went ahead anyway. Perhaps they sold at the top, I don't know; however, I do know what happened to the bank. It was in the S&P 500, yet it dropped in value by 84% due to all of the profligate lending in hot spots like Naples and Arizona, and was taken over by a foreign bank after the bubble burst. Lucky for me, I left the bank in 2005 and sold all of my stock immediately, telling fellow workers to do the same. Of course no one listened.

Speaking of that, I had another client in that same private bank that was a retired senior bank manager who owned millions of dollars' worth of the bank's stock. He was old enough to make a legitimate argument in favor of not diversifying his stock holdings so that his estate would get the step up in basis at death. However, when I saw the extent of the bubble that was forming, I told this man to start selling a little of his bank stock every year, just to be safe. He wasn't interested though, because he "knew" the bank was going to be fine. I asked him to sell stock on at least three occasions, but he never did. He saved the 20% capital gains tax all right, but he lost 84% of his investment, and about 70% of his net worth. A sad story, but unfortunately not unusual. I've seen this happen over and over. People can't seem to accept that the thing that made them wealthy might someday become a big loser.

I have often told people about the fate of those on the Forbes 400 list as a way to talk about concentration risk and cognitive dissonance. If you tracked those who were on the list at its inception, you would discover that by 2002, only 16% of the original members were still on the list. Now you only had to do two things to stay on the list: make 5.25% per year (Chart 6), and stay alive. Well, obviously, a number of people didn't stay alive, but an absolutely amazing number fell off the list because they couldn't make 5.25% per year. Remember now, that back then you could still buy CDs with that amount of interest on them. What could have happened then? Most of them saw their major stock holding (usually only one company) drop precipitously in a bear market (1987, 1998, 2002, etc.) and then not bounce back. Of course, this is an argument against concentration risk, but it also illustrates the level of cognitive dissonance that people experience when the facts are in conflict with their beliefs.

Chart 6: Forbes 400 Net Worth Over Time


Once again, we are seeing some cognitive dissonance develop as died-in-the-wool bulls believe the rally will never end and the Fed has their back forever, effectively regardless of the evidence to the contrary. These beliefs are demonstrably not true in both circumstances. Of course, rallies do eventually end, and the chart pattern for the New York Composite Index (Chart 7) today clearly shows the same kind of topping pattern that happened in 1999-2000 for the S&P 500 (Chart 8). Recall also that the Fed had our backs in 2008 and in 2000, dropping rates very low in each case, but the market dropped 54% and 49%, respectively, anyway. For another example, we can look at the high yield spreads in the last two years compared to historical periods when recessions were beginning (Chart 9).

Chart 7: New York Composite Index, Weekly Since 2013

Source: Author;

Chart 8: S&P 500 Index (SPX), Weekly 1998-2003

Source: Author;

Chart 9: High Yield Spreads to Treasuries


If investors want to survive and thrive, the avoidance of major drawdowns (Chart 10) that tend to follow on low expected return calculations (Chart 11) should be a major goal. That can only occur if the dangers of cognitive dissonance are avoided.

Chart 10: Drawdowns 1940-2010 After Low GMO Forecast Returns

Source: GMO;

Chart 11: GMO Seven-Yr. Forecast in March, 2016


It is not clear when the GMO forecast will result in a drawdown. However, many market indicators suggest high risk and unusual market behavior, according to the folks at It seems likely to me that current trends cannot stay in place much longer. At any point, a number of unpredictable events (e.g., China devaluing its currency, a Japanese or European banking crisis, etc.) could trigger a big market move without much advanced warning. Just in case, a small allocation to a managed futures fund like the AQR Managed Futures Strategy Fund (MUTF:AQMNX) could be put in place now. I would also consider making at least some allocation to a gold ETF such as the iShares Gold Trust ETF (NYSEARCA:IAU). Otherwise, I would remain defensive, so it makes sense to hold some intermediate to long Treasuries: the iShares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT), the Vanguard Intermediate Term Bond Fund (NYSEARCA:BIV), the PIMCO Total Return Active ETF (NYSEARCA:BOND), and the SPDR DoubleLine Total Return Tactical Bond Fund (NYSEARCA:TOTL); also defensive sector funds like the PowerShares S&P 500 Low Volatility Portfolio ETF (NYSEARCA:SPLV), and the iShares MSCI USA Minimum Volatility ETF (NYSEARCA:USMV); also some liquid alternatives like the Otter Creek Long/Short Opportunity Fund (MUTF:OTCRX), the AQR Long/Short Equity Fund (MUTF:QLENX), or the AQR Equity Market Neutral Fund (MUTF:QMNIX); and even some sophisticated hedge-like closed-end Fund strategies like the Nuveen S&P 500 Buy-Write Income Fund (NYSE:BXMX).

Disclosure: I am/we are long AQMNX, QLENX, QMNIX, OTCRX, BXMX, IAU, BIV, BOND, TOTL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.