The Trusting Investor Model
A trusting investor has faith that at least some people are trustworthy. This behaviour generally is based on past positive experience. If a person has behaved cooperatively and honestly in the past, the trusting investor assumes that the other person’s behaviour will continue into the future. Professor Stout remarks, “(Economists sometimes this describe this sort of backward-looking analysis as adaptive expectations to distinguish it form rational expectations)” (Stanford J. Grossman, An Introduction to the Theory of Rational Expectations under Assymetric Information, 48 Rev. Econ. Stud. 541, 543 (1981) – see reference list).
Trusting investors expose themselves to betrayal and fraud at least once, in contrast to the rational expectations investor. The fleecing of the trusting investor is likely a one-off proposition. Quoting Mark twain, “We should be careful to get out of an experience only the wisdom that is in it – and stop there; lest we be like a cat that sits down on a hot stove-lid. She will never sit down on a hot stove-lid again – and that is well; but also she will never sit down on a cold one any more” (Mark Twain, Following the Equator 124 (1897) – see reference list).
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Anectodal evidence, and common sense, suggest, if not demonstrate, that most investors in the financial markets behave as trusting investors. Negative reasoning proves this statement. Distrustful investors, that is, rational expectations investors, would avoid the markets. The information costs that the rational expectations must expend would discourage, if not persuasively convince the rational expectations investor to abandon the market given the size and complexity of modern securities exchanges and the diversity of products. Even if the rational expectations investor were to invest in a small portfolio of stocks, the number of people in a position to lie, cheat or steal is substantial and the rational expectations investor would want confirmation that at each stage effective external constraints were in place to prevent fraud. This hypothetical demonstrates that the costs outweigh the benefits thereby confirming that the majority of market investors fall under the Investor Trust Model.
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However, this hypothesis, if correct, has major implications for the market, as once burned, the trusting investor will not return to the market, as Mark Twain’s cat, once burned, will not sit on a stove-lid even if cold. Recent incidents, as well as history, do not bode well for the trusting investor model. While many instances of misconduct by corporate insiders and investment specialists may be cited, Enron and WorldCom provide paradigmatic examples of the scope and severity of harm corporate opportunism can visit upon the trusting investor, including employees purchasing employer stock on the recommendation of insiders and outsiders. These two cases, involving both unethical and illegal behaviour, no longer constitute an anomaly in the market, but represent the tip of the iceberg of mismanaged companies, misleading information, and the incompetence of “experts” to protect the public.
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Responding to the question of why investors purchase securities, Professor Stout states:
The answer is trust. American investors take it as a matter of faith that the brokers and mutual fund managers to whom they entrust their savings will use those funds to actually purchase securities on their behalf. They take it as a matter of faith that corporations that issue securities really exist, have real assets and make real profits. Because they have faith, American investors buy trillions of dollars of corporate securities each year, even when they are not quite sure what they are buying. [footnote omitted] (One could not ask for a more instructive example than Enron. Before its sudden and shocking collapse, the firm was routinely cited as one of the best run and most innovative companies in America, even though neither the shareholders who owned the stock nor the analysts who followed its progress really understood how Enron made its money(Lynn A. Stout, supra at 419 – see reference list)
This analysis of two models of investor behaviour poses sobering results. On the one hand, the rational expectations investor model, given its strict requirements, is an implausible explanation of why so many investors purchase securities in the market. On the other hand, the investor trust model is fragile, and a series of betrayals, will result in the investor leaving the market, as the betrayed investor will not subject to risk serious investments, such as those related to retirement funds. Prolonged bear markets are detrimental to the investor and provide incentive to search for alternative investments. Having established that the dominant profile of an investor falls under the Investor Trust model, the analysis turns to the main theories of how policymakers design protections for the investor.
