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 INTRODUCTION
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. Investors will price legal protections---or the lack thereof--when valuing securities. If financial intermediaries do not give credible assurances that they will not abuse their customers' trust, investors will not entrust them with their investment dollars. And if companies do not give credible assurances that they will disclose truthfully the information that investors rely upon to value securities, those companies will pay substantial risk premia (thereby compensating investors for the risk of fraud) or be unable to sell their securities altogether. We confess to having penned a few lines of this sort ourselves in prior work. (10) Adherents to behavioral law and economics are not so sanguine about investors' capacity to fend for themselves. They argue that arbitrage will not drive irrationality from the market but instead may fuel it: "Arbitrage is a double-edged blade: Just as rational investors arbitrage away inefficient pricing, foolish traders arbitrage away efficient pricing." (11) If mispricing is a persistent phenomenon, the behavioralists fear that investors left to the mercies of unscrupulous brokers and corporate executives will be systematically fleeced. Rejecting the laissez-faire normative outlook that underlies much law and economics scholarship, the behavioral economics school generally subscribes to an "anti-antipaternalism." (12) As any high school English teacher no doubt could translate, this means a belief in the benefit of "paternalism." (13) In the context of the securities regulation, this faith has a quite tangible object of worship: the Securities and Exchange Commission (SEC).
Several commentators use the evidence of cognitive defects among investors to justify preserving and expanding the role of the SEC. (14) In the absence of government regulation, greedy promoters will step into the void to prey on the cognitive defects of investors. Particular scorn is directed toward proposals to substitute market regulation for SEC oversight. (15) Market participants, the argument goes, will not precommit to regulatory protections to win the trust of investors but will instead manipulate investors' biases systematically to enrich themselves. (16) Competition cannot be relied upon to promote investor welfare because of the systematic nature of the biases. The small investor cannot count on the smart money to demand fair treatment for all investors--the smart money suffers from the same set of biases. Only government intervention can protect investors from their own cognitive defects.
While we think the magnitude of investor biases is open to question, (17) we focus on a different question here: If cognitive defects are pervasive, will intervention help? Even well-intentioned and fully rational regulators may find it difficult to solve the problem of cognitive illusions among investors. Disclosure, the prevailing regulatory strategy in the securities markets, may not protect investors if cognitive biases prevent them from rationally incorporating the information disclosed into their investment decisions. More fundamentally, if everyone suffers from cognitive defects, doesn't that also include the commissioners and staff of the SEC?
Regulators may respond that their expertise shields them from some cognitive illusions. The work of behavioral economists, however, shows that experts may fall prey to their own set of biases. (18) Moreover, regulators do not face the same competitive pressures that investors and other securities market participants do. (19) Those competitive forces may help mitigate behavioral biases among investors and securities professionals (at the very least forcing out of the market those with the greatest levels of cognitive difficulties). Regulators, by contrast, generally enjoy monopolies in their field, which immunizes them from the stringent constraints of the market that might force corrections in decision making flaws. If biases are universal, do regulators suffer more or less from those biases than investors? Markets deal harshly with fools; our cynical side worries that government affords a safe haven.
Not all commentators applying behavioral insights to securities regulations call unquestioningly for government intervention to correct for market-based biases. The possibility of regulator biases has led some to question the wisdom of regulation as a solution for market-based biases. (20) For those attempting to take into account regulator behavioral biases, the question nonetheless remains: How should policymakers weigh investors' behavioral biases against those affecting regulators? Obviously perfect regulation trumps an imperfect market. But we do not face this choice. Instead, we propose a framework for assessing regulation to correct for market biases. A cautious approach is warranted in this area because regulators themselves typically make the decision whether to intervene in the market. Overconfidence (or more mundane public choice reasons) may cause regulators to ignore their own behavioral limitations and push toward excessive intervention. Regulatory intervention to correct for biases also poses the very real danger of regulatory mistake. Once in place, new regulatory protections often take a life of their own, so even if regulations are ill conceived, they become difficult to displace. The market corrects its mistakes; regulators frequently resist doing so. Indeed, focusing on the behavioral problems of investors without also addressing the problems among regulators may lead to a perverse result. Investors--to the extent they are capable of learning and adjusting to cognitive limitations through feedback in the market--may come to rely (mistakenly) on regulators to protect them from themselves, (21) diminishing the market's ability to overcome behavioral biases on its own. We therefore argue that regulations designed to remove investment choices from individual decisionmaking require very strong justification. Other forms of regulatory interventions disrupt markets less. So, for example, we are more open to regulations intended to assist investors in overcoming their behavioral biases. Investor education might be one such...