Posted by on Mar 31, 2012 in Articles & Advice, Blog, Featured, Posts |

By Jason Zweig | Mar 28, 2012 2:50 pm ET

Image credit: Bonnie, “Jesus Is Coming…Look Busy (George Carlin), 2008, Wikimedia Commons


Some financial myths never seem to die. One is the delusion that the markets are full of “sophisticated investors.”

This week, the Municipal Securities Rulemaking Board, which helps regulate the sale of tax-free bonds, proposed a new definition of what makes a sophisticated investor. A “sophisticated municipal market professional” would be defined as an institutional client that “the [bond] dealer has a reasonable basis to believe is capable of evaluating investment risks and market value independently…” and “affirmatively indicates that it is exercising independent judgment in evaluating the recommendations of the dealer.”

As I wrote when Bernard L. Madoff’s Ponzi scheme broke, George Carlin would have loved the term “sophisticated investor.” It’s a natural addition to his famous rant on oxymorons like “jumbo shrimp,” “military intelligence,” “business ethics” and “plastic glass.”

Among the classic examples of “sophisticated investors” making idiots out of themselves:

* Robert Citron, the former treasurer of Orange County, Calif., leveraged the municipality’s investment portfolio with complex derivatives that exploded, blasting the county into bankruptcy. When Citron was asked how he could be certain that the portfolio was protected from the risk of rising interest rates, he declared: “I am one of the largest investors in America. I know these things.”

* Giant banks and investment firms worldwide gorged themselves on hundreds of billions of dollars’ worth of mortgage derivatives that quickly turned putrid. In fact, the most powerful firms on Wall Street used the supposed existence of “sophisticated investors” as a primary justification for dumping off their own risk.

* In 1995, some of the wealthiest and most “sophisticated” investors in America – including former U.S. Secretary of the Treasury William E. Simon, venture capitalist Laurance Rockefeller, hedge-fund manager Julian Robertson and the foundation of former Goldman Sachs co-chairman John Whitehead — were snookered out of millions of dollars by scam artist John G. Bennett Jr. (Their “sophistication” evidently didn’t make them immune to his claims that he had secret donors who knew how to double the value of donations every six months.)

The great economist Tibor Scitovsky, in his classic 1950 essay “Ignorance as a Source of Oligopoly,” pointed out that when goods and services are highly complex, buyers struggle to determine fundamental value and often end up relying on price and reputation as indirect signals of quality.

“The expert buyer has always been an exception,” wrote Scitofsky, “and the consumer is not only an inexpert buyer but the increasing complexity of consumers’ goods is constantly increasing his ignorance.”

As Scitofsky argued, the deliberate escalation of complexity enables sellers to compete on dimensions other than price and quality. In the ultimate irony, the sellers of complex products will promote themselves on the basis of their specialization in making ignorant customers feel “sophisticated.” (Just think: You used to have merely a “stockbroker” or a “financial planner.” Now you can have a “wealth manager”!)

As Warren Buffett has said, what matters isn’t how expert you are, but how well you understand the limits of whatever expertise you have. Psychologists have highlighted a critical pitfall with human expertise: The more people know, the more they come to believe they know even more than they actually do.

We’d all be better off if the term “sophisticated investor” were taken out to the back of the barn and buried under the manure pile, where it belongs.

Source: Total Return blog,,

Related: definition of “sophisticated investor” in The Devil’s Financial Dictionary