The Simple Paradigm Of Perfectly Reasonable Investors

Tom C. W. Lin

Temple University – James E. Beasley School of Law

95 Boston University Law Review, 461, 2015

Temple University Legal Studies Research Paper

Abstract:

Much of financial regulation is built on a convenient fiction. In regulation, all investors are identically reasonable investors. In reality, they are distinctly diverse investors. This fundamental discord has resulted in a modern financial marketplace of mismatched regulations and misplaced expectations — a precarious marketplace that has frustrated investors, regulators, and policymakers.

This Article examines this fundamental discord in financial regulation and offers a better framework for thinking anew about investors and investor protection. This Article presents an original typology of heterogeneous investors that exposes the common regulatory fallacy of homogeneous investors. It explains that the simple paradigm of perfectly reasonable investors, while profoundly seductive, is an inadequate foundation for designing investor protection policies in a complex, contemporary marketplace. It demonstrates how this critical divergence has harmed investors and regulators in the modern, high-tech marketplace. To begin addressing such harms, this Article advocates for a novel algorithmic investor typology as an important step towards better reconciling financial regulation with financial reality. Specifically, it illustrates how core concepts of financial regulation like regulatory design, disclosure, and materiality can pragmatically improve as a result of the new typology. This Article ultimately argues that in order to better protect all investors, financial regulation must shift from an elegantly false, singular view of reasonable investors towards a more honest, pluralistic view of diverse investors — from protecting one type of reasonable investors to protecting all types of reasonable investors.

The Simple Paradigm Of Perfectly Reasonable Investors – Introduction

Investors exist everywhere, in every form.1 They reside in big cities and small towns, in magnificent mansions and modest apartments. They are famous as well as anonymous. They are financiers and farmers, old retirees and new workers, homemakers and fund managers, public employees and private entrepreneurs, sole proprietorships and partnerships, people and corporations. Yet for all their diversity, financial regulation frequently treats them monolithically as “the reasonable investor.”2

This Article is about that diversity, its dissonance from financial regulation, and the need for new legal understandings of investor protection to better harmonize financial regulation with financial reality.3 It offers one of the first sustained examinations of contemporary investors, highlights serious flaws in outdated rules designed to protect them, proposes a new investor typology for a fundamentally changed marketplace, and explains the effects of such a proposal on law and finance.

While much of the regulatory and scholarly attention since the financial crisis has been given to the large monolithic institutions at the apex of the financial marketplace,4 this Article shifts the focus to the base of the marketplace. Building upon the author’s previous works on new financial technology, and drawing on a rich body of literature that spans law, finance, psychology, and economics,5 this Article presents an original examination of the diverse participants at the frontlines of finance: the investors.

The objective of this Article is not to assert that financial regulation is completely blind to the differences among investors, nor is it to declare that decades of investor protection efforts are fatally flawed. It is acknowledged and understood that regulators are aware of the differences among investors in designing imperfect, but workable rules for investor protection.6 Rather the objective herein is more nuanced, more practical, and two-fold: this Article seeks to make a general positive claim and a specific normative claim. First, the general positive claim contends that a fundamental dissonance between investor heterogeneity in reality and investor homogeneity in regulation has created significant discontent in financial markets for both regulators and investors.7 Second, the specific normative claim argues that policymakers should formally recognize a new typology of algorithmic investors as an early step towards better acknowledging contemporary investor diversity, so as to forge more effective rules and regulations in a fundamentally changed marketplace.8 Together, this two-part objective aims to highlight the harms caused by not better recognizing contemporary investor diversity and explain how we can begin to address those harms. Collectively, this Article aspires to create a new and better framework for thinking about investors and investor protection.

This Article constructs this framework in four parts. Part I provides a typology of diverse investors. It begins with the bedrock paragon of the reasonable investor that is the central character of financial regulation. It then introduces other types of investors that deviate from the bedrock paragon in terms of cognition, activism, wealth, and personhood. It exposes the varying types of reasonable investors in the modern marketplace in contrast with regulatory theory’s dominant, singular type of reasonable investors. In doing so, Part I presents a lineup of distinct investors and reveals a fundamental incongruity in financial regulation.

The Simple Paradigm Of Perfectly Reasonable Investors

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