The Unsophisticated Sophisticated: Old Age And The Accredited Investors Definition
Texas Tech University
Texas Tech University
Chris Browning
Texas Tech University
July 22, 2015
Abstract:
Accredited investors are able to buy unregistered securities such as private equity, venture capital and hedge funds with little regulatory oversight. This lack of oversight is justified because investors who meet the accredited investor thresholds ($200,000 annual income/$300,000 for a couple, or a net worth of over $1 million excluding primary residence) are assumed to be sophisticated enough to understand these complex and opaque securities. Some have argued that income and wealth thresholds are not necessarily an accurate proxy of financial sophistication.
We use financial literacy instruments from the Consumer Finance Monthly and from the Health and Retirement Study to explore whether accredited older households, who are more likely to experience age-related cognitive decline and who have accumulated significant lifecycle savings, are less financially literate than younger unaccredited respondents. In both data sets, we find that accredited households age 80 and older are more than 80% less likely than unaccredited investors age 60-64 to have high financial literacy scores. Respondents with less than a high school degree were more likely to have a high financial literacy score than older accredited respondents in a multivariate analysis. While accredited investors are more financially literate than unaccredited investors within each age group, older accredited investors had significantly and strongly lower financial literacy scores than younger unaccredited investors and the difference increased consistently with age.
The Unsophisticated Sophisticated: Old Age And The Accredited Investors Definition – Introduction
Accredited investors are able to participate in unregistered securities offerings such as private equity, venture capital and hedge funds. These unregistered securities are also called Regulation D offerings because they are regulated under the U.S. Securities and Exchange Commission (SEC)’s Regulation D of 1982. Based on the current SEC ruling, an individual investor is qualified as an accredited investor if he has an annual income over $200,000 ($300,000 for a married couple) or a net worth over $1 million excluding primary residence.
The purpose of SEC Regulation D is to preserve a balance between investor protection and capital formation. By exempting some securities issuers from regular SEC registration and disclosure requirements, the SEC aims to reduce transaction costs for small businesses and facilitate the acquisition of outside capital. Limiting these Regulation D offerings to accredited investors is intended to restrict the purchase of these complex investments to investors who are sophisticated enough to “fend for themselves” and who can withstand significant losses (Sargent, 1990; GAO, 2013).
Regulation D offerings are important to the capital acquisition of small business. According to the GAO (2013), the amount of capital raised through Regulation D reached over $1 trillion in 2011 – which is comparable to the amount of capital raised through public security offerings. Considering that Regulation D securities are only available to a small percentage of the population that meets accredited investor thresholds, the size of Regulation D offerings is quite significant.
Regulation D can increase the vulnerability of unsophisticated wealthy investors by withholding traditional investor protections. Investors with significant wealth and low financial sophistication will be more attractive to opportunistic sales practices by less scrupulous financial services professionals. Regulation D offerings are usually less liquid and operate in a more opaque market. Since there are lower information disclosure requirements on the issuers, unsophisticated accredited investors can be particularly vulnerable to sales of unsuitable products. Regulation D also prohibits general solicitation or general advertising of Regulation D offerings. With the limitation of solicitation, individuals with whom a brokerage firm has had pre-existing substantive relationships may receive frequent offers to participate in exempt transactions. Unsophisticated wealthy individuals are more likely to invest in financial products that may lead to an overly risky and undiversified portfolio (Friedman, 1994). Even financially sophisticated accredited investors may not have the specific knowledge needed to avoid attractively-presented investment opportunities that are suboptimal, but are aggressively sold because they generate high broker commissions.
The intent of income and net worth thresholds for accredited investors is to ensure that participants have sufficient financial experience, sophistication and adequate bargaining power (GAO, 2013). This sophistication presumably reduces opportunities for inefficient agency conflicts in a market with high information asymmetry by limiting buyers to only those with the ability to effectively evaluate securities and monitor issuers. The store of knowledge needed to evaluate the quality of complex securities is a form of human capital that may be increased through investment in information acquisition (Lusardi and Mitchell, 2014). The acquisition of a larger stock of financial knowledge is motivated by the expected ability to make better financial decisions and earn higher expected returns on investments. Similar to the economics of education, an individual will invest more in their financial human capital if the future benefit of this investment is higher, or the cost of obtaining the knowledge is lower.
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