 The SEC has decided to do away with its price band misadventure. While a properly regulated market is in everyone’s best interest, the nature of the regulation and its impact are far more important than having a set of rules as a showpiece. At the heart of the problem the SEC faces is the thankless task of limiting speculation in a market that has returned over 600% during the last two years.
The difficulty though is that financial regulations always have been written mainly by lawyers and parliamentarians - then promptly shot full of holes by promoters who understand how real human beings think and behave. In my view, it is high time we adopt a behavioural approach. The cornerstone of such an approach is to admit that investors can never be completely educated about investments nor the risks associated with all the various types of investment products. Asking investors to be completely educated about investments is akin to asking patients to know everything that various specialist doctors know about diagnosing and healing health problems.
Investing is a full time profession. Unfortunately, many assume it to be a fun hobby and end up burning their entire life savings attempting it. The professionals who are there to help the general public (only brokers and personal bankers in the case of Sri Lanka) aren’t any better as few are required to abide by a strict fiduciary duty of care and whose remuneration is tied to increasing turnover or selling their institutions products. This conflict of interest disposes them of providing any meaningful, trustworthy and independent advice.
Investing is a full time profession. Unfortunately, many assume it to be a fun hobby and end up burning their entire life savings attempting it. |
Care must also be taken that we don’t go down the route of Western disclosure regimes which at times runs into hundreds of pages requiring a law school education to understand. What matters aren’t reams of paper disclosing all the various things that can go wrong with an investment. The choice architecture - the context, format and framing of how decisions are presented to consumers – would be more helpful than the length of disclosure and should be the real focus of regulators.
While investing, being a profession, makes complete education of the masses a challenge, the very nature of human beings is what makes financial literacy an almost insurmountable task. Expectations about future outcomes are what make clamping down speculation hard. Expectations of continuing price gains together with the perceived wisdom of crowds drive asset prices towards unsustainable heights, until the bubble is broken (often quite dramatically) by a completely unexpected event.
What accounts for these sudden moves? Why do investors so often seem to resemble a school of fish, all changing direction together? Sometimes the most interesting answers to financial questions come from scientific labs. A recent biological study found that the value you place on something is likely to go up when other people tell you it is worth more than you thought, and down when others say it is worth less. More strikingly, if your evaluation agrees with what others tell you, then a part of your brain that specializes in processing rewards kicks into high gear.
In other words, investors often go along with the crowd because—at the most basic biological level—conformity feels good. Moving in herds doesn't just give investors a sense of "safety in numbers." It also gives them pleasure. That may help explain why market sentiment can change so swiftly, why true contrarians are so hard to find and why investors care so much about the "consensus view"?
The brain scans during the experiment showed that as soon as people learned they had the same choice as the experts, cells in the ventral striatum—a reward centre wired with dopamine neurons that respond to pleasures like sugar and sex—fired intensely. Why might other people's estimates of what something is worth lead you to change your own? Their appraisal could make you unsure that yours is correct.
You might become more popular once you agree with others, or joining the experts may make you feel like one yourself. We are very social creatures, who are desperately keen to be part of a group. When someone influences you, it happens very quickly, in under a second, which can then travel quite quickly through a population.
The experiment also suggests that the agreement of others may have a special ability to grab our mental attention. No wonder a consensus opinion is almost impossible for many investors to ignore and why speculation is something regulators can never control.
Regulation that recognizes the limits of human rationality is an idea whose time has come. Of course, the financial industry will adjust its own behaviour, trying to outsmart the new rules as fast as they are printed. But the war between the regulators and the regulated might finally be based on a realistic view of human nature, not fantasy.
(Kajanga is an Investment Specialist based in Sydney, Australia. You can write to him at kajangak@gmail.com). |
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