Abstract
The findings of behavioural finance research Have undoubtedly influenced the traditional understanding of the processes and patterns that allow the financial markets to function. (A good collection of early key papers is Kahneman et al., Judgment under uncertainty: Heuristics and biases, 1982; see also Kahneman and Tversky, Choices, values, and frames, 2000; legal implications stemming from behavioural findings are described by Korobkin and Ulen, Calif Law Rev 88:1051–1144. See also Moloney, How to protect investors: lessons from the EC and the UK, pp. 67–74, 2010 regarding the irrational and uninformed investor) Perceptions, which used to be based on the assumptions of rational behaviour gradually allow for human flaws (Cunningham, Wash.Lee Law Rev 59:836, 2002 resumes that behavioural finance is “a marriage of cognitive psychology and the financial economics of market inefficiency”). Not only the structural information asymmetries between the various financial market participants interfere with the efficient allocation of capital; moreover, there is also a need to address other factors that may substantially influence markets, such as emotions, reference biases, overconfidence and inertia impair rational choice (However, the role of psychology in economics was already discussed by Keynes, The general theory of employment, interest, and money, p. 315, 1936 referring to animal spirits (162) and unrealistic optimism or pessimism as causes for booms and busts). Since such insights from the field of behavioural economics are often not in line with the common legislative model developed on the basis of the rational investor concept, the question arises which possible reactions of the law (especially of financial market law) to the insights provided by other disciplines might be valuable (An interesting exemplification showing the reaction of law in response to biased decision-making processes is the justification of the business judgment rule as a yardstick which can be seen as a limitation of the hindsight bias that otherwise would affect the judges; see Rachlinski, University of Chic Law Rev 65:574, 1998: “For example, in corporate law, the business judgment rule protects corporate officers and directors from liability for negligent business decisions because, in part, of the tendency for adverse outcomes to seem inevitable” and p. 625: “The business judgment rule and subsequent remedial measures rules, for example, make a great deal of sense as a response to hindsight bias”). Today’s approach towards the point-of-sale (POS) regulations for investment advisory and portfolio management services includes a mandatory assessment regarding the individual appropriateness and suitability of financial investments (Already Rapp, Ohio North University Law Rev 24:189, 1998 stated in relation to financial industry standards of conduct that none is “more frequently cited, and least objectively applied, than the ‘suitability’ requirement”). The following analysis of presently debated regulatory code-of-conduct-requirements fostering investor protection is based on behavioural findings.
The illusion that we understand the pastfosters overconfidence in our ability to predict the future
Daniel Kahneman (Thinking, fast and slow, 2011, p. 218)
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Notes
- 1.
- 2.
MiFID stands for Market in Financial Instruments Directive, 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments, 30.4.2004, OJ L 145/1-44.
- 3.
In the OECD G20 High-Level Principles on Financial Consumer Protection, published in October 2011, <http://www.oecd.org/regreform/liberalisationandcompetitioninterventioninregulatedsectors/48892010.pdf>) the principle Disclosure and Transparency is stressed in sect. 4; the following formulation exemplifies that this principle is clearly understood in a comprehensive manner: “Financial services providers and authorised agents should provide consumers with key information that informs the consumer of the fundamental benefits, risks and terms of the product. They should also provide information on conflicts of interest associated with the authorised agent through which the product is sold.” Addressing risks it is stated: “The provision of advice should be as objective as possible and should in general be based on the consumer’s profile considering the complexity of the product, the risks associated with it as well as the customer’s financial objectives, knowledge, capabilities and experience. Consumers should be made aware of the importance of providing financial services providers with relevant, accurate and available information.”
- 4.
- 5.
The first question is whether it is possible to overcome undesirable biases. Depending on adequate measures this seems to be at least partially possible. The subsequent questions are whether it is advisable to do so and whether law could be an appropriate corrective; see Cunningham 2002, p. 787, with further references. Cognitive biases, e.g. overconfidence , can have valuable positive effects, but they should not be ignored by the market actors and regulators.
- 6.
See for a god overview also the World Bank working paper from Boskovic et al. 2010.
- 7.
- 8.
E.g. Shiller 2000.
- 9.
- 10.
Camerer et al. 2003.
- 11.
In principle, Bayes’s theorem in says that the probability of a hypothesis (the posterior probability ) is a function of new evidence (the likelihood) and previous knowledge (prior probability).
- 12.
Ben-Shahar and Schneider 2010, p. 42, are summing up some relevant studies: “A standard test of numeracy asks people how often a flipped coin comes up heads in 1000 tries, what 1 % of 1000 is, and to turn a proportion (1 in 1000) into a percentage. 30 % of women of above-average literacy ‘had 0 correct answers, 28 % had 1 correct answer, 26 % had 2 correct answers, and 16 % had 3 correct answers’ (Schwartz et al. 1997). Most of the people in another study had at least some college education, but 40 % ‘could not solve a basic probability problem or convert a percentage to a proportion’ (Lipkus et al. 2001). No wonder that ‘after receiving quantitative risk reduction data about the benefit of mammography, most women did not apply this information correctly when asked to estimate their risk for death from breast cancer with and without mammography’; (accuracy ranged from 7–33 %; Schwartz et al. 1997).”
- 13.
Avgouleas 2009, p. 453–454; Shiller 2005, p. 154; see also FSA 2009, The Turner Review, A Regulatory Response to the Global Banking Crisis, pp. 40–41, where this phenomenon is described.
- 14.
Sunstein and Thaler 2003. Some of the findings might be criticised while based on laboratory experiments, but the real-world performance seems in average not to be any better. Only some learning effects can improve the decision-making process; see on anchoring and overconfidence : De Bondt and Thaler 1990; Shiller 2000, pp. 136–147.
- 15.
Grether 1980.
- 16.
- 17.
This means preferring A to B as well as B to A. In the legal context, see Sunstein et al. 2002 .
- 18.
Frederick et al. 2002.
- 19.
- 20.
Camerer et al. 2003, p. 1215.
- 21.
Tversky and Kahneman 1974, p. 1124 , stated, that relying on the representativeness heuristic to judge probabilities “leads to serious errors, because similarity, or representativeness, is not influenced by several factors that should affect judgments of probability.” Individuals tend to disregard familiar common facts codetermining probabilities under uncertainty while focusing only on facts before their face.
- 22.
Simon 1955, pp. 103–110.
- 23.
- 24.
- 25.
Kahneman et al. 1991 .
- 26.
- 27.
Charness and Rabin 2002, pp. 849–51 found that individuals are concerned with increasing social welfare; Fehr and Schmidt 1999, pp. 855–56 looked at an economic environment determining whether fair or selfish types dominate; Loewenstein et al. 1989, pp. 438–39 worked on social utility functions that could be used to predict individual behaviour in situations where decisions had personal as well as consequences for another party; Rabin 1993, pp. 1281–82 looked at a “fairness equilibrium” in which people like to help those helping them and hurt those who are hurting them.
- 28.
- 29.
- 30.
Camereret al. 2003, p. 1218.
- 31.
Smith1892, originally 1759, p. 311 .
- 32.
Camerer and Loewenstein 2004, p. 5.
- 33.
- 34.
See <http://en.wikipedia.org/wiki/List_of_cognitive_biases>. For a good overview regarding investor biases see Pompian 2012.
- 35.
Akerlof and Shiller 2010.
- 36.
“Cognitive biases are heuristic strategies operating at a subconscious level […]”; Cunningham 2002, p. 787.
- 37.
Kahneman and Tversky 1979 . Neumann and Morgenstern 1944. A prospect is a gamble (x, p, y, q) that pays x with probability p and y with probability q.
- 38.
Thaler 1980, pp. 41–43.
- 39.
This is especially true when we hold on to assets based on the former purchasing price and are not willing to accept that only the current price and the future potential should be assessed.
- 40.
Jolls 2006, p. 4. The Coase theorem is a centerpiece of law and economics; basically it states that allocating legal rights to one party or another will not affect outcomes if transaction costs are sufficiently low; see Coase 1960.
- 41.
Jolls et al. 1998, p. 1550.
- 42.
Thaler 1980, pp. 43–47.
- 43.
Samuelson and Zeckhauser 1988.
- 44.
Gal 2006.
- 45.
Regret aversion bias is the tendency to avoid making a decision due to the fear of the later probability to experience the pain of regret; in consequence, people will avoid taking decisive actions because they fear that, in hindsight , whatever action they may select could prove less than optimal.
- 46.
Kahneman 1990 were working with chocolate bars and mugs; different from an experiment with tokens subjects who initially were given mugs rarely sold them, while those not initially given mugs seldom bought them. Shogren et al. 1994 criticised the situation of artificial scarcity in this experiment and found by using the same goods little evidence of the endowment effect . However, the experiment by Carmon and Ariely 2000 using basketball tickets confirmed the endowment effect.
- 47.
Shefrin and Statman 1985.
- 48.
Thaler 1984.
- 49.
- 50.
Camerer and Lovallo 1999, p. 306.
- 51.
Barber and Odean 2001.
- 52.
Barber and Odean 2001.
- 53.
Svenson 1981.
- 54.
Kahneman 2011, p. 255.
- 55.
Kahneman 2011, p. 85 et seq .
- 56.
“There are known knowns; there are things we know that we know. There are known unknowns; that is to say, there are things that we now know we don’t know. But there are also unknown unknowns—there are things we do not know we don’t know.” Donald Rumsfeld, February 2002; <http://www.defense.gov/transcripts/transcript.aspx?transcriptid=2636>. Additionally their might be unknown (unconscious) knowns.
- 57.
Avgouleas 2009 makes those two proposals for reform.
- 58.
However, the grey capital market, closed-end funds and investment companies will remain a challenge.
- 59.
MiFID II proposal Art. 24 (5); European Commission proposal for a Directive of the European Parliament and of the Council on markets in financial instruments repealing Directive 2004/39/EC of the European parliament and of the Council, Brussels, 20.10.2011; <http://ec.europa.eu/internal_market/securities/docs/isd/mifid/COM_2011_652_en.pdf>.
- 60.
According to Hens and Rieger 2008, p. 27 most of the common structured products do not “follow rational guideline, but instead use behavioral factors, like loss-aversion or probability misjudgment to be attractive in the eyes of potential investors”.
- 61.
KI(I)D (Key Investor (information) Document) and PRIP (Packaged Retail Investment Product); see Commission Regulation (EU) No 583/2010, OJ L 176, 1.7.2010, 1-15; Commissions Proposal for a regulation on key information documents for investment products, COM (2012) 352, 3.7.2012, <ec.europa.eu/internal_market/finservices-retail/docs/investment_products/20120703-proposal_en.pdf>.
- 62.
See Article 33 of the level 2 MiFID -ID (MiFID Implementing Directive, Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, 2.9.2006, OJ L 241/26–58) regarding the obligation to inform clients about costs.
- 63.
According to Rapp 1998, p. 212, “the most common characterization offered is that suitability is an amorphous concept, with no accepted definition, and bereft of case law guidance”.
- 64.
Cunningham 2002, p. 797. At 788: “It also means that such investor education must include not only tutelage in the principles of finance and insights from behavioral finance, but also explanation of how these axioms may collide.”
- 65.
See below 5.1. NASD (National Association of Securities Dealers) is the former name of the American self-regulatory organization for broker-dealers, which is now consolidated with the member regulation, enforcement and arbitration functions of the New York Stock Exchange FINRA (Financial Industry Regulatory Authority). Founded and registered with the SEC in 1939 the NASD was based on the 1938 Maloney Act amendments to the Securities Exchange Act of 1934. NASD as the one and only “Registered Securities Association” supervised the conduct of its members under the oversight of the SEC. Section 15A of the Securities Exchange Act of 1934 was enacted in 1938 to extend regulatory authority under the federal securities laws to the over-the-counter securities markets. NASD created a system of cooperative regulation of broker-dealers and was responsible for the adoption and enforcement of the rules to protect investors and the public interest.
- 66.
Cunningham 2002, p. 798.
- 67.
Anderson and Winslow 1992, p. 105.
- 68.
Anderson and Winslow 1992, p. 118.
- 69.
Moloney 2008, p. 614.
- 70.
The theory applying in principle the concept of fair pricing and full disclosure had its origins in early SEC administrative cases like re Duker & Duker, 6 SEC 386, 388 (1939) and Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943). In Hughes a broker-dealer lost his license because he charged 40 % more than the market price and did not disclose true market prices to investors; he petitioned to overturn the revocation, but the Court of Appeals found (446) that someone who “actively solicits customers and then sells them securities at prices far above the market as were those which petitioner charged here must be deemed to commit fraud”. Emphasising the (i) financial literacy of the investors (“…customers were almost entirely single women or widows who knew little or nothing about securities….”), (ii) information asymmetry (“expert knowledge and proffered advice”) of the broker-dealer; and (iii) the reliance of investors (“confidence… instill[ed] in the customers”) a theory of fiduciary responsibility resulted; see Ormsten, Franklin D. 1998, Securities Arbitration Commentator, Vol. X, No. 8, available at <http://www.sacarbitration.com/shingle.htm>.
- 71.
Mundheim 1965, p. 450.
- 72.
Laby 2011; not originally mentioned in the Investment Advisers Act from 1940 fiduciary duties are assumed since that decision from 1963.
- 73.
- 74.
Rule 2310 is the former (since 1939) Article III, § 2 of the NASD Rules of Fair Practice.
- 75.
Business with the other categories eligible counterparties and professional investors and the opting-in/out provision are not relevant here.
- 76.
MiFID Article 19 (4) and (5).
- 77.
The current MiFID suitability requirements are set out in Art. 19 (4) of MiFID and Art. 35 of the MiFID-ID; the current MiFID appropriateness requirements are set out in Art. 19 (5) and (6) and Art. 36–38 of the MiFID-ID. MiFID Article 19 (6) (together with Article 38 of the MiFID-ID) allows to skip the appropriateness test for certain types of ‘execution-only’ business, if all of the following criteria are met: (i) execution only of orders involving shares admitted to trading on a regulated market, UCITS and other non-complex financial instruments; (ii) the service is provided at the initiative of the client; (iii) the client is informed that there is no suitability assessment; (iv) compliance with Art. 18 of MiFID (conflicts of interest).
- 78.
While eligible counterparties are more or less exempted from the conduct of business regime it applies in principle to the other two categories retail and professional investors. There are different ways to qualify as a professional: (i) There are specified professionals like financial institutions or pension funds; (ii) investors who meet specific turnover, balance-sheet and capital criteria; (iii) public bodies with specific financial tasks; (iv) other institutional investors. All of them may request non-professional status. On the other hand it is possible to opt in to be classified as professional on request providing that competence and asset-based fitness tests are met. See Moloney 2008, pp. 595–597.
- 79.
Moloney 2008, p. 599.
- 80.
- 81.
Available at <http://www.esma.europa.eu/system/files/2012-387.pdf>.
- 82.
The guidelines are based on the relevant legislation: for this example additional on Art. 13(2) of MiFID and Art. 5 of the MiFID-ID.
- 83.
See Rapp 1998, 193, who already 15 years ago stated, that “guided by principles of Modern Portfolio Theory (MPT), the offending recommendation may take on a markedly different character. Indeed, instead of being an “unsuitable” investment, the risky security may be seen as a wise investment that is consistent with, if not in fact compelled by, a responsible portfolio investment objective that is well-suited to the customer”.
- 84.
Moloney 2012, p. 179.
- 85.
Moloney 2012, p. 177.
- 86.
Opening statement of Steven Maijoor, Chair of ESMA, at the ESMA Investor Day, 12 December 2012, Paris; <http://www.esma.europa.eu/system/files/2012-_818.pdf>.
- 87.
Rapp 1998, p. 189.
- 88.
Decision 4A_525/2012, 3 February 2012, E. 3.3; see also BGE 133 III 97 E. 5.4.
- 89.
FINMA report, Madoff-Betrug und Vertrieb von Lehman- Produkten: Auswirkungen auf das Anlage beratungs- und Vermögensverwaltungsgeschäft, 2. March 2010, <http://www.finma.ch/d/finma/publikationen/documents/bericht-lehman-madoff-20100302-d.pdf>.
- 90.
See FINMA Distribution report, 2; the report especially noted that the risk awareness and risk appetite of customers was insufficiently clarified and the offered products were not sufficiently tailored to their personal risk capacity.
- 91.
The revision of FINMA-Circ. 2009/1, Guidelines on asset management, sets out the duties of asset managers when dealing with clients. The revised circular entered into force on 1 July 2013 and the end of 2013 rules of conduct are to be adjusted; <http://www.finma.ch/e/regulierung/Documents/finma-rs-09-01-e.pdf>.
- 92.
Although the Federal Court ruled in its decision, 4A_140/2011, 27. June 2011, in favour of the bank because of the clients’ experience, in E. 2.1 (clients‘ risk profile) and in E. 3.1 (inquiring of clients‘ readiness to assume risk) the risk element within the suitability assessment was accentuated.
- 93.
Newly inserted were margins 7.1: “Taking the clients’ experience and knowledge into consideration, a risk profile should be drawn up, outlining the clients’ risk tolerance and risk capacity.” and 7.2: “The investment strategy is to be defined with clients based on their risk profile , financial situation and investment restrictions .” Accordingly, margin 17 was also extended. Asset managers used to be obligated to review the investment strategies employed on a periodical basis; now it is to be assessed “whether the clients’ risk profile is in line with their current financial circumstances. If this is not the case, clients are to be made aware of this and it must be written down”.
- 94.
BGE 138 III 755; BGE 132 III 460.
- 95.
See the analysis from Nosić and Weber 2010 regarding determinants of risk taking behaviour, finding that risk taking behaviour is affected by subjective risk attitudes, risk perception and return expectations. They argue (29–30) that “objective measures of risk, such as historical volatility and return, are not able to determine risk taking behavior nearly as well as subjective measures, i.e. subjective risk and return perceptions”.
- 96.
See Vrecko et al. 2009.
- 97.
Nosić and Weber 2010 (30 of the SSRN-version) state that behavioural biases such as overconfidence and excessive optimism significantly affect risk behavior and suggest that the advisory process could try to incorporate some of these findings to correct “investors’ erroneous beliefs”. Therefore, enhancing the financial literacy of customers and explaining that some investments are more risky than initially perceived.
- 98.
Kahnemann and Tversky 1979, p. 273, reported that the majority of subjects chose B in the first problem and C in the second.
- 99.
Within that discussion key cognitive biases should be addressed: “(1) reference-point-related issues (including conservatism, excessive loss aversion , and frame dependence); (2) probabilistic analysis issues (including representativeness and overconfidence ); and (3) mental errors (the brain functioning outside of one’s awareness—namely, anchoring , regret and addiction).” See Cunningham 2002, p. 792.
- 100.
Weber et al. 2012 analysed differences in self-reported risk attitude during the interesting time slot from September 8 to June 9 under online brokerage investors and reported substantial changes in risk taking over that period of time. They find (p. 31 of the SSRN-version) regarding the subjective judgments of risk and return expectation “that it is the more emotion-based components of these judgments that drive changes in risk taking”. Not the risk attitude itself changed but the personal awareness towards it—after the experience of losses.
- 101.
SMSG (Securities and Markets Stakeholder Group), Advice to ESMA, 15 February 2012, 2; <http://www.esma.europa.eu/content/Advice-Guidelines-certain-aspects-MiFID-suitability-requirements>. The SMSG is composed of 30 individuals who represent financial market participants, their employees’ representatives, and consumers, users of financial services, including ten from financial institutions and five academics.
- 102.
SMSG-Advice to ESMA (supra note 107), p. 6.
- 103.
SMSG-Advice to ESMA (supra note 107), p. 8.
- 104.
ESMA Guidelines (supra note 87), p. 33.
- 105.
Hens and Bachmann (2008), p. 105.
- 106.
See Cunningham 2002, p. 799, who also emphasizes the significance of loss aversion : “Of all the biases and factors that one could possibly ask about, however, one’s degree of loss aversion is striking for its relevance, reliability, and accessability. Loss aversion relates directly to problems of regret (a universal characteristic of claimants in nonsuitability cases); it is a good indicator of the sorts of securities that would or would not make the investor comfortable, and it is relatively easy to elicit through conversion and observation.”
- 107.
Hens and Bachmann 2008, p. 106.
- 108.
See Rapp 1998, pp. 243–244.
- 109.
The Modern Portfolio Theory is widely used in practice in the financial industry, but the basic assumptions are challenged by the findings of behavioural economics . See Markowitz 1952.
- 110.
Systematic risk is defined as the covariance between an individual security or mix of assets in a portfolio and the market in general. A high volatility of a security or a portfolio in relation to the market volatility implies a greater systematic risk, which is expressed numerically as the beta coefficient based on regression analysis of historical data.
- 111.
Lucarelli and Brighetti 2011 provide detailed analysis relating risk with focus on Italy.
- 112.
Opening statement of Steven Maijoor, Chair of ESMA, at the ESMA Investor Day, 12 December 2012, Paris; <http://www.esma.europa.eu/system/files/2012-_818.pdf>.
- 113.
In 2014 the Federal Council will launch the consultation on FSA (FIDLEG ). This contribution was finished before this process was started.
- 114.
See Jolls 2006, pp. 39–40.
- 115.
Moloney 2010, pp. 243, advocates mystery shopping.
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This contribution was written within the University Research Priority Program Regulation of Financial Markets from the University of Zurich.
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Baisch, R., Weber, R. (2015). Investment Suitability Requirements in the Light of Behavioural Findings. In: Mathis, K. (eds) European Perspectives on Behavioural Law and Economics. Economic Analysis of Law in European Legal Scholarship, vol 2. Springer, Cham. https://doi.org/10.1007/978-3-319-11635-8_9
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