The Rational Investor Model
According to the rational expectations model, “investors behave like members of the species homo economicus: they are cool, calculating and purely self-interested actors” (Lynn A. Stout, supra at 410 – see reference list). The rational investor also assumes that other participants in the market, such as corporate managers, brokers, money managers, are equally calculating, self-interested actors in the marketplace. Therefore, using Professor Stout’s analogy, the rational investor approaches the markets as one would approach a chess game. It is assumed that, given the opportunity, the adversary of the rational investor will steal his/her money, as a chess champion would take a queen if exposed. Consequently, under this model, the rational investor will not part with its hard earned cash without adequate restraints placed upon the corporate managers, brokers, and money managers.
The following quotation poignantly captures this dichotomy:
“This means that a rational expectations investor will only be willing to plunk down her hard earned dollars to buy stocks, bonds, mutual fund shares if she is presented with evidence sufficient to persuade her that corporate insiders, and securities professionals face external constraints adequate to discourage them from stealing and shirking, and external rewards sufficient to give them incentive to run their firms and clients’ portfolios well and profitably. To return to the chess analogy, the rational expectations investor will not move her queen to an open space on the board until she is sure the other player can’t take it. Rational expectations investors do not invest on faith. They take nothing for granted.” (Ibid. at 410-11 – see reference list)
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Since the rational investor presumes that corporate insiders and securities professionals would not hesitate to lie, cheat or steal, this model requires a legal regime that constrains corporate opportunism. If the legal system lacks effective external constraints, the rational investor will withdraw from the market, refusing to invest. This model necessarily adopts the Efficient Capital Market Hypothesis, maintaining that the price of securities accurately reflects their intrinsic value. Without that implication, the rational expectations investor will not purchase securities, as the investor will lack evidence of quality investments.
The rational expectations investor model has shaped several legal regimes in the construction of investment protection. A notable example of this argument emanates from a landmark article by Professor Roberta Romano in the Yale Journal (Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 Yale L.J. 2359 (1998) – see reference list). In her article, Professor Romano argues that the United States should permit corporations selling financial instruments to select the legal regime, under which they would be regulated, conceivably even regimes countenancing fraud. She argues that a rational expectations investor would shirk away from any unprincipled legal system, as the rational expectations investor requires effective external constraints against corporate opportunism. She says, “it is silly to contend that investors will choose regimes that encourage fraud” (Ibid. at 2368 – see reference list).
Professor Romano’s theory demonstrates how the rational expectations investor model has shaped discourse in the domain of securities policy. Judge Easterbrook, in an article written when he was a professor at the University of Chicago went so far to say that the argument that securities laws are necessary to protect unsophisticated investors is “as unsophisticated as the investors it is supposed to protect” (Frank H. Easterbrook and Daniel R. Fischel, Mandatory Disclosure and Protection of Investors, 70 Va. L. Rev. 669, 694 (1984) – see reference list).
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Yet, the legislative evidence of any sophisticated legal regime supports a contrary viewpoint and argument. For example, in the United States, post-Great Depression legislation such as the 1933 Securities Act and the 1934 Securities Exchange Act, and the plethora of subsequent amendments and laws designed to protect the investor undercut the rational expectations investor model. The European Union is not different, as evidenced by the Prospectus Directive, the MiFID Directives, the Market Abuse Directive and the Directives against Insider Dealing. The mandate of disclosure and laws forbidding fraudulent market activity serve as the backbone of investor protection in the financial markets (Regrettably, the legal infrastructure is less than fully effective at achieving its goals. Typically, it is reactionary, responding to incidents after they occur, and often the speed at which the Legislator acts may produce misguided legislation such as Sarbanes-Oxley, even though the EU has adopted what may be termed a “mini” Sarbanes-Oxley” act, subsequent to the EU outcry against the US legislation when first enacted).
