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Behavioral Economics and the SEC Law & Economics Working Papers Law & Economics Working Papers Archive: 2003-2009 University of Michigan Law School Year 2003 Behavioral Economics and the SEC Stephen Choi∗ Adam C. Pritchardy ∗University of California, Berkeley, [email protected] yUniversity of Michigan Law School, [email protected] This paper is posted at University of Michigan Law School Scholarship Repository. http://repository.law.umich.edu/law econ archive/art12 Choi and Pritchard: UNIVERSITY OF MICHIGAN JOHN M. OLIN CENTER FOR LAW & ECONOMICS BEHAVIORAL ECONOMICS AND THE SEC ADAM C. PRITCHARD WORKING PAPER #03-002 THIS PAPER CAN BE DOW NLOADED WITHOUT CHARGE AT : MICHIGAN JOHN M. OLIN CENTER WEBSITE HTTP://WWW.LAW .UMICH.EDU/CENTERSANDPROGRAMS/OLIN/PAPERS.HTM Published by University of Michigan Law School Scholarship Repository, 2003 1 Law & Economics Working Papers Archive: 2003-2009, Art. 12 [2003] Behavioral Economics and the SEC Behavioral24.doc: 3/20/03 12:22 PM Stephen J. Choi* & A.C. Pritchard** Abstract. Investors face myriad investment alternatives and seemingly limitless information concerning those alternatives. Not surprisingly, many commentators contend that investors frequently fall short of the ideal investor posited by the rational actor model. Investors are plagued with a variety of behavioral biases (such as, among others, the hindsight bias, the availability bias, loss aversion, and overconfidence). Even securities market institutions and intermediaries may suffer from biases, led astray by groupthink and overconfidence. The question remains whether regulators should focus on such biases in formulating policy. An omnipotent regulatory decisionmaker would certainly improve on flawed investor decisionmaking. The alternative we face, however, is a behaviorally-flawed regulator, the Securities and Exchange Commission (SEC). Several behavioral biases may plague SEC regulators including overconfidence, the confirmation bias, framing effects, and groupthink. While structural solutions are possible to reduce biases within the agency, we argue that such solutions are only partially effective in correcting these biases. Instead of attempting to determine when the behavioral biases of regulators outweigh those within the market, we take a different tactic. Because behaviorally flawed (and possibly self-interested) regulators themselves will decide whether market-based biases outweigh regulatory biases, we propose a framework for assessing such regulatory intervention. Our framework varies along two dimensions. The more monopolistic the regulator (such as the SEC), the greater is the presumption against intervention to correct for biases in the market. Monopolistic regulatory agencies provide a fertile environment for behavioral biases to flourish. Second, the more regulations supplant market decisionmaking, the greater is the presumption against such regulations. Market supplanting regulations are particularly prone to entrenchment, making reversal difficult once such regulations have become part of the status quo. * Professor of Law, University of California, Berkeley (Boalt Hall). ** Assistant Professor, University of Michigan Law School. The authors thank Jennifer Arlen, Mitu Gulati, Andrew Guzman, Kim Krawiec, Jim Krier, Don Langevoort, Ronald Mann, Un Kyung Park, Jeff Rachlinski and participants at the University of Michigan Law School Fawley Lunch, the Washington University, St. Louis School of Law Faculty Workshop, the Georgetown University Law Center Sloan Workshop and the University of North Carolina School of Law Faculty Workshop for helpful comments. Pritchard acknowledges the generous financial support of the Cook Fund of the University of Michigan Law School. http://repository.law.umich.edu/law_econ_archive/art12 2 Choi and Pritchard: I. INTRODUCTION ..............................................................................................................................................................1 II. THE BEHAVIORAL APPROACH TO SECURITIES REGULATION............................................................7 A. INVESTOR BIASES............................................................................................................................................................. 7 B. BIASES OR PREFERENCES? ............................................................................................................................................ 13 C. THE QUESTIONABLE IMPORTANCE OF BIASES........................................................................................................... 15 III. BEHAVIORAL BIASES WITHIN THE SEC ....................................................................................................20 A. CATALOGING THE BIASES AT THE SEC....................................................................................................................... 21 1. Bounded Search........................................................................................................................................................ 22 2. Bounded Rationality................................................................................................................................................. 24 3. Availability, Hindsight and Fundamental Attribution Biases........................................................................... 26 4. Framing Effects......................................................................................................................................................... 28 5. Overconfidence......................................................................................................................................................... 30 6. Confirmation Bias.................................................................................................................................................... 32 7. Groupthink................................................................................................................................................................. 36 B. CORRECTIVE MECHANISMS.......................................................................................................................................... 38 1. Internal Organization .............................................................................................................................................. 39 2. Judicial Review......................................................................................................................................................... 41 3. Political Oversight................................................................................................................................................... 42 C. OTHER EXPLANATIONS FOR REGULATORY FAILURE AT THE SEC ......................................................................... 44 IV. ASSESSING REGULATION TO CORRECT BIASES ...................................................................................46 A. REGULATORY DECISIONMAKERS................................................................................................................................. 49 1. Monopolistic Regulators......................................................................................................................................... 50 2. The Courts ................................................................................................................................................................. 52 3. Competitive Regulators........................................................................................................................................... 57 B. FORMS OF REGULATORY INTERVENTION.................................................................................................................... 63 1. Restricting Investment Options.............................................................................................................................. 64 2. Adjusting Existing Securities Regulation............................................................................................................. 69 3. Influencing Investors................................................................................................................................................ 74 C. APPLYING THE FRAMEWORK........................................................................................................................................ 80 V. CONCLUSION ..................................................................................................................................................................82 Published by University of Michigan Law School Scholarship Repository, 2003 3 Law & Economics Working Papers Archive: 2003-2009, Art. 12 [2003] I. 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
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