Behavioral Finance and Economics- Cognitive Distortions - Why Risk Disclosure May Not Sink In

"When the facts change, I change my mind. What do you do sir?"

- John Maynard Keynes

Well let's explore the answer to his query a bit.

Did you ever wonder why investors tend to ignore warnings of risk in disclosure documents even after reading the warnings?

An obvious answer is that the disclosure document is too long or too complex or both.  That may be and that may be the answer to my question.  But it might also be something else.

You may wish to consider the following:

In my November 30th Observation I pointed out two human psychological tendencies described by Charlie Munger, Doubt Avoidance and Inconsistency Avoidance. I reproduce Munger's "Long Talk" descriptions below:

Doubt-Avoidance Tendency

The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision.  It is easy to see how evolution would make animals, over the eons, drift toward such quick elimination of doubt.  After all, the one thing that is surely counterproductive for a prey animal that is threatened by a predator is to take a long time in deciding what to do.  And so man's Doubt Avoidance Tendency is quite consistent with the history of his ancient, nonhuman ancestors.

Inconsistency-Avoidance Tendency

The brain of man conserves programming space by being reluctant to change, which is a form of inconsistency avoidance.  And so, people tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often reexamined or changed, even though there is plenty of good evidence that they are wrong.

Munger goes on to describe the power of Doubt-Avoidance and its consequence (a quick decision about something).  He points out that society recognizes this problem and in some cases takes special care to see to it that it does not occur.

So pronounced is the tendency in man to quickly remove doubt by reaching some decision that behavior to counter the tendency is required from judges and jurors.  Here, delay before decision making is forced.

So when a broker first brings a potential investment to the attention of a client powerful psychological tendencies come forcefully into play.  First, as I mentioned in my Observation on December 15th a strong bond of trust develops (or is in place already) stretching from the client to the broker.  This bond of trust causes a cognitive distortion to occur in the client the net effect of which is to act as a factual input filter.  This filter lets in favorable information and excludes other (most importantly contradictory) information.  The filter stays in place as long as the bond of trust from the client to the broker continues to exist.


Second, the doubt avoidance tendency reinforces this bond of trust information filter.  In our scenario though there are no jury instructions given to a client to withhold judgment until all of the sources of information have been reviewed.  Even with an expression to the contrary (let me review the disclosure documents) the client has either made the investment decision or is primed to make it with significant cognitive distortions in place.


But we are not done yet with cognitive distortions.


The inconsistency avoidance tendency (at least as powerful as the other two) also comes into play.  This is another tendency that causes us to filter out non-confirmatory information we encounter.  Warren Buffett, Munger's partner, calls this the "First Conclusion Bias."  Mr. Buffett is often quoted (e.g. The Real Warren Buffett at p.210) in regard to the power of this tendency as he details Charles Darwin's method for defeating this bias.  According to Buffett, Darwin used to say that whenever he ran into something that contradicted one of his earlier conclusions, he would write down the new information within 30 minutes.  Otherwise his mind would soon work to reject the discordant information.


Now consider that the broker has presented the investment opportunity and perhaps given marketing materials to the client in connection with the presentation prior to the delivery of the disclosure documents.  These three tendencies are powerful forces for mere clients (as opposed to Darwin) to overcome when the disclosure documents do arrive.  All of these forces create cognitive distortions which act as filters causing the client to ignore or even reject risk disclosure in the disclosure documents which is not identical in detail and tenor to that initially conveyed explicitly or even implicitly by the broker.  This process occurs without the client's recognition that it has even happened. Blame our ancestors for that.


It would be amusing to watch Darwin read a disclosure document. I wonder how many of those little notebooks he would use up.