Behavioral Economics and the SEC
Choi, Stephen J., Pritchard, A. C., Stanford Law Review
INTRODUCTION I. THE BEHAVIORAL APPROACH TO SECURITIES REGULATION A. Investor Biases B. Biases or Preferences? C. The Questionable Importance of Biases II. BEHAVIORAL BIASES WITHIN THE SEC A. Cataloging the Biases at the SEC 1. Bounded search 2. Bounded rationality 3. Availability, hindsight, and fundamental attribution biases 4. Framing effects 5. Overconfidence 6. Confirmation bias 7. Groupthink B. Corrective Mechanisms 1. Internal organization 2. Judicial review 3. Political oversight C. Other Explanations for Regulatory Failure at the SEC III. ASSESSING REGULATION TO CORRECT BIASES A. Regulatory Decisionmakers 1. Monopolistic regulators 2. The courts 3. Competitive regulators B. Forms of Regulatory Intervention 1. Restricting investment options 2. Adjusting existing securities regulation 3. Influencing investors C. Applying the Framework CONCLUSION
Not all investors are rational. Quite apart from the obvious examples of credulity in the face of the latest Ponzi scheme, there is no shortage of evidence that many investors' decisions are influenced by systematic biases that impair their abilities to maximize their investment returns. (1) For example, investors will often hold onto poorly performing stocks longer than warranted, hoping to recoup their losses. (2) Other investors will engage in speculative trading, dissipating their returns by paying larger commissions than more passive investors. (3) And we are not just talking about widows and orphans here. There is evidence that supposedly sophisticated institutional investors--mutual funds, pension funds, insurance companies--suffer from similar biases that impair their decisions. (4) These biases are not merely isolated quirks, rather, they are consistent, deep-rooted, and systematic behavioral patterns. Apparently even the considerable sums at stake in the securities markets are not enough to induce market participants to overcome these cognitive defects on a consistent basis.
Not surprisingly, these findings of scholars working at the intersection of psychology and economics have recently found their way into legal scholarship. This burgeoning trend has come to be called "behavioral law and economics." (5) Behavioral law and economics is defined primarily by what it rejects: the rational actor model that is the fundamental premise of conventional law and economics. The rational actor model postulates that individuals shrewdly calculate the course of action that will maximize their wealth and utility. (6) This presumption is bolstered in market settings, where economically minded commentators commonly assume that the most rational will dominate in competition with those less cognitively able.
In the context of the securities markets the rational actor model has considerably less Darwinian implications than one might suppose. Under the Efficient Capital Market Hypothesis, (7) the "smart" money will set prices and through the process of arbitrage will swamp the influence of the poorly informed or foolish. Even the unsophisticated therefore can rely on market efficiency to ensure that the price he pays for a security will be "fair." More importantly, the unsophisticated can accomplish their investment goals by passively tracking the overall market without evaluating individual companies and the securities that they issue. (8) Far from weeding out unsophisticated investors, the overwhelming influence of smart money actually indirectly protects the interests of the poorly informed, as evidenced by the burgeoning popularity of index funds. (9)
The more provocative implication of the efficient market hypothesis is that government regulation of financial intermediaries and companies' financial disclosures may be unnecessary and potentially wasteful. …