Cognitive Biases and Investor Protection Regulation an Evolutionary Approach

Abstract:     
Based on the findings of cognitive psychology and experimental economics, Behavioural Decision Theory (BDT) has mounted a powerful challenge on the Standard Social Sciences Model of hyper-rationality. In this mode, the notion of fully informed investors making rational choices in order to maximize gains, one of the main theoretical foundations of modern investor protection regulation, has been heavily challenged. Although BDT's findings are not as inconsistent with rational choice theory as initially suggested, this does not mean that public policy-makers and financial market regulators should ignore the least controversial of the findings of BDT. This article provides a number of suggestions for the gradual incorporation of certain of BDT's insights, such as those explaining investors' bounded rationality and the impact of specific cognitive biases, in four areas of investor protection regulation: investment advice, investment promotions, mandatory disclosure, and asset management. Suggested measures include further fragmentation of investor classes for the purposes of protective regulation, pluralism in the prescribed volume of information disclosed to various investor classes, regulatory prescriptions of the structure ('framing') of investment promotions, and the mandatory use of long-term performance targets for fund managers. Although such measures would amount to soft paternalism, they are justified by the distracting effect of certain cognitive biases on investor and market welfare. Furthermore, the use of economic experiments, can facilitate the identification of optimal disclosure formats and assist in the ex ante evaluation of new regulatory measures.

Number of Pages in PDF File: 72

Keywords: Behavioral Decision theory (BDT), Investor protection regulation, FSA, conduct of business rules, mandatory disclosure, cognitive biases, psychology of choice and judgment, framing effect, behavioural finance, stock market bubbles, experimental economics.

JEL Classification: G15, G28, K22, D81

working papers series