Conservatism Bias: Why Investors Are Too Slow to React to New Information

Warren Buffett opens this chapter with a quote about needing a sound framework for decisions and the ability to keep emotions from corroding that framework. Chapter 5 is about one specific way emotions corrode it: by making you too slow to update your beliefs.

What Is Conservatism Bias?

Here’s the thing about conservatism bias. It is basically your brain’s software running with outdated data.

You form a view about something. Then new information comes in that contradicts your view. A rational person would update their beliefs. But a conservatism-biased person clings to the old view. They underreact to the new data.

This is closely related to cognitive dissonance from the previous chapter. But where cognitive dissonance is about avoiding mental pain, conservatism is more about mental laziness. Processing new information takes effort. Your brain would rather stick with what it already “knows.”

The Urn Experiment

Pompian describes a classic 1968 experiment by Ward Edwards that shows this perfectly.

Imagine two urns. One has 3 blue balls and 7 red balls. The other has 7 blue balls and 3 red balls. Someone draws 12 balls from one urn (putting each ball back after drawing), and gets 8 red and 4 blue.

Question: what is the probability the draw came from the first urn (the one with more red balls)?

The correct answer is 0.97. Almost certain.

But here’s the problem. Most people guess around 0.7. They overweight the base rate of 0.5 (the random chance of picking either urn) and underweight the actual evidence from the draws.

This is conservatism bias in a lab. People anchor to their prior belief (50/50 chance of either urn) and don’t adjust enough when they see real data.

Why Does This Happen?

Professor Hirshleifer from Ohio State had an interesting explanation. Processing new information is mentally expensive. When information comes in a complex or abstract form, like statistics or accounting reports, people give it less weight. It is just hard to process.

But when information is easy to understand, like a vivid story or a concrete example, people might actually overreact to it.

So the brain is not consistently conservative. It is lazy. Easy information gets too much weight. Hard information gets too little.

This explains a lot about how markets work, if you think about it. A dramatic headline moves stock prices more than a dense earnings report, even when the earnings report contains more useful information.

How Analysts Get It Wrong

James Montier, who wrote a book on behavioral finance and worked as an analyst in London, studied this bias among securities analysts. His findings are damning.

Analysts cling to their forecasts. They only change them when presented with “indisputable evidence” that they were wrong. Montier’s data showed that analysts are basically experts at telling you what already happened. They are terrible at updating their views in real time.

If professional analysts who do this for a living suffer from conservatism bias, imagine how regular investors handle it.

Three Ways This Hurts Your Portfolio

Pompian outlines three specific problems:

1. Clinging to views when you should be updating. You bought a stock because the company was about to launch a new product. Then the company announces problems bringing that product to market. But instead of reevaluating, you hold onto your original optimistic view. “The product will still be great, they just need more time.”

2. Reacting too slowly when you do react. Even when conservatism-biased investors finally acknowledge bad news, they move too slowly. The stock keeps dropping while they are still thinking about whether to sell. By the time they act, they have lost more money than necessary.

3. Avoiding complex information. A company announces complicated accounting changes that might affect growth. Instead of trying to understand the changes, you just ignore them and stick with your prior belief that the company is doing great. The old belief is simple and comfortable. The new information is confusing and threatening.

Underreaction and Overreaction in Markets

This chapter gets really interesting when Pompian discusses research by Barberis, Vishny, and Shleifer from the University of Chicago.

They found evidence that markets sometimes underreact to news and sometimes overreact. Both patterns exist.

Underreaction: When a company announces surprisingly good earnings, the stock price goes up, but not enough. Over the next six months, it slowly drifts up to where it should have been on announcement day. If you bought right after the announcement, you would profit from this drift.

The same works in reverse. Bad news drops a stock, but not far enough. It keeps drifting down for months.

Overreaction: When good news keeps coming for 3 to 5 years, investors get too optimistic. They push prices way too high. Then reality kicks in and prices correct downward. Past losers become future winners, and past winners become future losers.

So here’s the practical takeaway. In the short run (6 months), momentum works because of underreaction. In the long run (3 to 5 years), value investing works because of overreaction. This is one of the most useful insights in the whole book so far.

What To Do About It

Pompian’s advice is simple but not easy to follow.

First, don’t cling to forecasts. When new information arrives, honestly ask yourself: does this change my thesis?

Second, when the right course of action becomes clear, act quickly. Don’t let the old belief linger and delay your decision.

Third, if you don’t understand new information, get help. Ask an advisor. Do more research. Don’t just ignore complex data because it is hard to process.

I grew up in a country where official information was unreliable. You had to constantly update your mental models based on new signals. People who couldn’t adapt quickly lost a lot more than money. So conservatism bias feels personal to me. The ability to quickly process new information and actually change your behavior is not just an investing skill. It is a life skill.

The market does not care about your prior beliefs. It only cares about what is happening now.

Previous: Cognitive Dissonance

Next: Confirmation Bias

This is part of a series retelling “Behavioral Finance and Wealth Management” by Michael M. Pompian. Start from the beginning.