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Cognitive Limitations to Understanding Complex Investments

Posted by Jack Duval

Feb 17, 2014 8:50:58 AM

This blog post continues our expert analysis of complex investments.

Cognitive research has shown that humans have severe limits on the amount of information that can be received, processed, and remembered.  In this post, we explore the research and compare it to the task presented to an investor when reading a prospectus.

Digit Span

Humans have a limited ability to simultaneously hold multiple objects in their mind.  There is a very large literature on this topic within the cognitive psychology field.  It is a part of working memory research and comes under the aegis of “digit span”.

Digit span is the way psychologists measure the ability of working memory to store objects.  For example, if a subject was presented with four numbers and could repeat them back in order, but could not do so with five numbers, their digit span would be four. 

The average person has a digit span of seven and most people have a digit span between five and nine.  This is known as Miller’s Law, and is based on one of the most heavily cited papers in the history of cognitive psychology.[1]  As Miller wrote:

… the span of absolute judgment and the span of immediate memory impose severe limitations on the amount of information that we are able to receive, process, and remember.

This rule is the reason why telephone numbers are seven digits long.

Miller also found the ability to judge differences between objects was limited as well.  For example, the ability of subjects to distinguish between auditory tone, auditory loudness, the saltiness of water, and the position of points on an interval began to plateau at four and declined thereafter.[2]

Complex Span

Since the 1950’s, research on working memory has expanded to include many other versions of digit span.  One of these is known as “complex span”, which tasks the subject with recalling objects (as in the digit span test), while also having them process separate tasks at the same time.   (For example, solving a simple math problem.)

As could be expected, recall is worse in complex span than in simple span tests.  That is, the ability to hold objects in the mind declines as subjects have to process other tasks at the same time.[3]

The research on digit and complex span can be applied to understanding complex investments.  An investor tasked with understanding a prospectus is faced with having to potentially hold hundreds of objects in their mind simultaneously while also having to process different kinds of mathematical, financial, and economic problems.

Variable Universal Life Insurance Contract - Policy Loan

As an example of this task, we have mapped parts of a variable universal life insurance contract that apply to taking a policy loan.  The defined terms are in red.  All the defined terms would need to be simultaneously held in the investor's mind to understand how policy loans work. Furthermore, understanding the entire map is required to understand the first sentence.

To download a higher resolution image, click here.

Accelerant_Complex_Investment_VUL_Policy_Loan_Map

 

Reading a prospectus is a complex span task.  It is also many orders of magnitude harder than having to recall a sequence of letters while also doing simple math problems.  Yet delivery of a prospectus is a key component of disclosure obligations for Registered Representatives and Investment Advisors.

If investors cannot understand a prospectus, they are reliant upon their financial advisor to understand it for them and to judge the investment's risk and suitability for the investor.

___________

The Accelerant roster of securities experts with complex investment backgrounds includes:

Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.

Notes

[1]            George A. Miller.  “The Magical Number Seven, Plus or Minus Two: Some Limits on Our Capacity for Processing Information”; Psychological Review, (1956).  Available at: http://www.musanim.com/miller1956/.  Accessed February 17, 2014.

[2]                 Id.

[3]                 For a simple explanation of this, see: Helen Tam, Christopher Jarrold, and Alan D. Baddeley, Domain-Specific Effects of Processing On Working Memory Performance.    Available at: http://www.esrc.ac.uk/my-esrc/grants/RES-062-23-0148/outputs/Download/2124f645-eb6f-46b7-bfc6-8f6f4eb4bb05.  Accessed February 17, 2014.

 

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