Cognitive Errors As Canary Traps

Abstract

When otherwise intelligent investors fail to correct an error, a researcher learns something about what these investors did not know. The investors must not have known about anything which would have allowed them to spot their mistake. If they had, they would have stopped making it. I show how a researcher can use this insight to identify how investors price assets. If X predicts returns, then any correlated predictor that investors know about but researchers have yet to discover represents a potential confound. I define a special kind of error, called a “cognitive error”, which otherwise intelligent investors will only fail to correct if they are not aware of any such omitted variables. So when investors fail to correct a priced cognitive error about X, then a researcher can be sure that investors are pricing assets based on X. Cognitive errors are instruments for identifying how mostly rational investors price assets.