51 Pages Posted: 1 Apr 2010 Last revised: 8 Oct 2010
Date Written: March 1, 2010
Financial innovations have resulted in an explosion in the number of so-called structured products being offered in the retail marketplace. To explain the complex structure of these hybrid debt securities, their prospectuses frequently employ numerical examples to illustrate the investment’s return formula. These depict hypothetical reward scenarios, utilizing an atypical set of premises. Consequently, these example sets portray highly unlikely investment results. Behavioral science, particularly consumer information processing and principles of numeracy generally, reveal that these “illustrative” example sets can and do create a highly skewed picture of the investment’s potential returns. The target investor’s innumeracy and cognitive biases thus can be leveraged strategically by issuing firms. This latent form of deception has enormous implications for the retail investing population, implications that are only beginning to be felt and understood given the timing of the popularity of these investment instruments and their medium term maturity dates.
Armed with research at the intersection of behavioral law and behavioral finance, the authors propose a measured regulatory response. A focused regulation restricting the use of numerical examples that give rise to unrealistic investor expectations is consistent with other regulators’ responses to implied messages of typicality, it is consistent with the law relative to disclosure of issuer projections, and it is consistent with the limited interventionist approach favored by most scholars who have addressed the question of regulation as a method of de-biasing investors. The proposed regulation preserves the important policy objective of investor choice, leaving sophisticated investors with structured notes as a menu option when creating their portfolios, but it also prevents the inevitably mistaken inferences that motivate more innumerate retail investor purchases.
Keywords: consumer information processing, numeracy, behavioral law and economics, securities regulation, reward disclosures, quantitative disclosures, numeric illustrations, derivatives, hybrid securities, structured notes, structured investment products, behavioral finance, investor error, cognitive biases
JEL Classification: K22, G11, G18, D14, D18, D03
Suggested Citation: Suggested Citation
Olazábal, Ann Morales and Marmorstein, Howard, Structured Products for the Retail Market: Regulatory Implications of Investor Innumeracy & Consumer Information Processing (March 1, 2010). Arizona Law Review, Vol. 52, p. 623, 2010. Available at SSRN: https://ssrn.com/abstract=1580998