Manne on behavioral finance

Henry Manne has an important op-ed in today’s WSJ about behavioral finance.

Henry’s says that, while “the efficient market mavens were indeed correct in their factual conclusions about aggregate market behavior,” they couldn’t explain how markets were efficient given individuals' irrational behavior. He concludes that the law shouldn’t inhibit trading based on theories of irrationality and that “the Supreme Court’s “fraud on the market” theory of civil liability under the federal securities laws and Congress’ ideas of correct civil damage claims for insider trading would seem no longer to have any intellectual merit.”

The article began as remarks at a Lewis & Clark conference on the implications of behavioral finance. One of the papers it responded to was my Fraud on a Noisy Market, 10 Lewis & Clark Law Review 136 (2006). And so here is my response.

My article summarized some of the evidence on market inefficiency that has been produced by the behavioral finance people. I think Henry has always interpreted my paper as a defense of behavioral finance. However, it would be more accurate to say that I'm agnostic on that subject. My aim is to show that, even if the behavioral finance theorists are right, this tells us little or nothing about what the law should do.

Specifically, even assuming investor irrationality leads to inaccurate pricing, trying to address this through regulation and liability rules raises serious questions about the effect of this liability on, among other things, encouraging frivolous lawsuits; increasing investors' overconfidence by convincing them that securities trading is safe; and inhibiting investor learning to correct judgment errors (see Jonathan Klick & Gregory Mitchell, Government Regulation of Irrationality: Moral and Cognitive Hazards).  It also forces us to rely on courts and regulators who have their own judgment biases (see Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1(2003).

My article focuses on the serious questions that behavioral finance raises about the application of the fraud on the market theory. Among other things, behavioral finance theory suggests that this theory may impose liability that is unconnected to any misconduct by defendants. I suggest an interpretation of the Supreme Court's opinion in Dura that would minimize this problem.

I conclude:

the rapid growth in behavioral finance theories should remind us how much we still do not know about how capital markets work. Just twenty years ago the Supreme Court in Basic was confident enough about the efficient capital markets hypothesis to make it a foundation of liability for securities fraud. Now both Congress and the Court have expressed significant reservations about FOM. We should remember this history before remaking securities fraud law in the image of behavioral finance and risking another round of expansion and retrenchment. Behavioral finance theory teaches that people can be overconfident. Courts and regulators should keep this in mind.

So, although Henry and I start from different assumptions about market efficiency, we get to the same conclusion about regulation. The difference is that I don’t have to argue with all the people who insist that markets are inefficient. I can just send them to argue with Henry.