Image Credit: Heath Hinegardner
By Jason Zweig | April 24, 2010 12:01 a.m. ET
Without full and proper disclosure, investors can’t make an informed decision. Even with full and proper disclosure, however, many investors still can’t make an informed decision.
That is the unspoken irony at the heart of the Securities and Exchange Commission’s lawsuit against Goldman Sachs.
Don’t get me wrong. One of the most fundamental tenets of financial regulation is that forewarned is forearmed. Without good disclosure, the markets can’t function. I’m not saying that Goldman—which denies all wrongdoing and any material omission—shouldn’t have disclosed to buyers that short sellers at Paulson & Co. helped put together the now-notorious Abacus deal.
What I am saying is that telling investors what they need to know is necessary, but insufficient. Receiving information and using it wisely are two entirely different things. Regulators, rightly, focus on ensuring that disclosure is provided. But investors struggle with using it wisely. As the Nobel Prize-winning economist Herbert Simon warned: “Information consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention.”
Consider a recent analysis of disclosures by Ambac and MBIA, two specialty insurance companies. Each quarter, in forms they file with state regulators, such firms must list any significant exposures they may have to the same kinds of derivative securities that are under dispute in the SEC’s case against Goldman. The insurers posted the filings on their own Web sites; with a little digging, investors could find them.
Robert Bartlett, a law professor at the University of California, Berkeley, found that Ambac and MBIA’s state filings—plus other public information from the Irish Stock Exchange Web site—gave ample disclosure about the derivatives to which they were exposed. But on the days when the credit ratings of those derivatives were massively downgraded, the share prices of Ambac and MBIA barely budged relative to the market. Only when the insurers issued earnings announcements that showed the cumulative losses did investors finally take notice and sell Ambac and MBIA’s stock.
“It was apparently very difficult even for institutional investors to contend with the amount and volume of noise in the market in 2008,” Prof. Bartlett says.
Even if disclosures are easy to think about, investors still may not focus on what matters most. A team of economists, including David Laibson of Harvard, tested whether investors would favor the lowest-cost choice among four index funds if the importance of fees was hammered home in a one-page “cheat sheet.”
The good news: By presenting a simplified emphasis on fees, the researchers tripled the number of investors who favored the lowest-cost funds. The bad news: That tripling brought the proportion up only to 9% from 3%. “We still ended up with a 91% failure rate,” says Prof. Laibson. Encouraged to focus on fees, investors nevertheless fixated on—and chased—past performance.
Disclosure can also backfire. Psychologists Daniel Simons and Christopher Chabris are co-authors of The Invisible Gorilla, a forthcoming book explaining why humans so often fail to observe information that should be obvious. Prof. Chabris suggests that the more comprehensive a prospectus seems, the more likely investors are to conclude, “All you need to pay attention to is within the four corners of this document.” That, in turn, may lull investors out of any urge to do further research and exercise independent judgment.
Regulators still should push for better disclosure, but every investor also should rely on a standardized checklist of questions that must be answered before any purchase. Perhaps the most important: If I am buying, someone else is selling. What, exactly, do I know that this other person may have overlooked?
For investors who profited from the credit crisis, the answer often lay outside the prospectus: in visiting housing developments or in picking apart one mortgage pool at a time.
Benjamin Graham, perhaps the most astute analyst Wall Street has ever produced, was once asked whether he thought disclosure was adequate. Graham replied that the quantity of disclosure “makes me ill.” He added, “I don’t know if there is any solution … I suppose [a prospectus] would have to say in big red-letter words, THIS [SECURITY] IS NOT WORTH WHAT IT IS SELLING FOR. I don’t know if that would make any difference either … somebody [would just say], ‘What the hell, it is going up anyway.'”
You can lead an investor to disclosure, but you can’t make him think.
Source: The Wall Street Journal
For further reading: Chapter V, “What Publicity Can Do,” in Louis Brandeis’ book Other People’s Money (1913)