Making money from cognitive dissonance

Yesterday, I wrote a post on how people look for advice that confirms their pre-existing beliefs. But what happens when reality hits you with data that contradicts these beliefs? The result is cognitive dissonance, and Odhrain McCarthy has shown nicely how investors can make money from other people’s cognitive dissonance.

Obviously, you can’t make money from your cognitive dissonance because the very nature of it is that your pre-existing beliefs are at odds with the information you got about your investments, for example. But we all are experiencing cognitive dissonance from time to time, and we all have problems resolving it. It takes time to change your view. And you can exploit this in stock markets.

There is a group of investors who publicly announce their beliefs about specific stocks. They are commonly known as ‘equity analysts’ and their beliefs are nicely standardised into Buy, Hold, and Sell recommendations.

What happens when a company that has a Buy recommendation from an analyst disappoints with its results? What happens when a company with a Sell recommendation surprises to the upside? In these cases, analysts are facing cognitive dissonance and have to grapple with themselves whether they should change their recommendation on the stock or stick with their existing beliefs.

And as they grapple with that decision, stock prices start to drift. What McCarthy found was that the post-earnings announcement drift in share price is stronger and lasts longer for stocks where the earnings surprise contradicts the consensus recommendation for the stock. The charts below show the abnormal return in the 90 days after an earnings release for companies with a Buy or a Sell recommendation. The post-earnings announcement drift is more than twice as strong for companies with a Sell consensus that surprise to the upside as for companies that have a Buy consensus. And the picture reverses for earnings misses.

Post earnings announcement drift by consensus recommendation

Source: McCarthy (2025)

A simple trading strategy that invests after earnings have been released in companies with a Sell consensus rating and positive earnings surprises, and shorts companies with a Buy consensus rating that missed earnings estimates, creates a much larger performance than doing the opposite or the traditional standard post-earnings announcement drift strategy. Indeed, between 1997 and 2023, the average monthly abnormal return was about 1%. That annualises to 12.6%.

Trading strategy exploiting cognitive dissonance

Source: McCarthy (2025)