A Behavioral Framework for Securities Risk

This Article provides the first critical analysis and redesign of the existing securities risk disclosure framework given new insights from the emerging, interdisciplinary field of behavioral economics. Disclosure is the principle at the heart of federal securities regulation. Beneath that core principle of disclosure is the basic assumption that the reasonable investor is the idealized über-rational person of neoclassical economic theory. Therefore, once armed with the requisite information investors presumably can protect themselves through rational choice.

Descriptively, however, real investors are not like their rational, neoclassical kin. This Article examines this incongruence between the idealized rational investor and the imperfect actual investor, explores the consequences of this incongruence on risk assessment in investments, and highlights several shortcomings of risk disclosures as a result of it. Then, to address these shortcomings, this Article argues for a better capture of the advantages of disclosure-based risk regulations, and proposes a new behavioral framework for securities risk disclosure built on relative likelihood and relative impact of dynamic risks. In doing so, this Article challenges the conventional wisdom that securities risk management should be done primarily through increased government oversight and enforcement, and promotes the underappreciated utility of disclosure as a powerful, complementary risk management tool in the modern financial regulatory landscape.

In advocacy of this contention, this Article closes with a discussion of key implications of the proposed framework, namely how it could improve disclosure drafting, simplify transparency, increase financial literacy, lower information costs, and enhance financial arbitrage.