Abstract

Financial innovations have resulted in an explosion in the number of so-called structured products being offered in the retail marketplace. To explain the complex structure of these hybrid debt securities, their prospectuses employ numerical examples to illustrate the investments' return formulas. These examples depict hypothetical reward scenarios, utilizing an atypical set of premises. Consequently, the example sets portray highly unlikely investment results. Behavioral science, particularly consumer information processing and general principles of numeracy, reveal that these "illustrative" example sets can and do create a highly skewed picture of an investment 's potential return. The target investor's innumeracy and cognitive biases thus can be strategically leveraged by issuing firms. This latent form of deception has enormous implications for the retail investing population—implications that are only beginning to be felt and understood given the timing of these investment instruments' popularity and their medium-term maturity dates.

Armed with research at the intersection of behavioral law and behavioral finance, the Authors propose a measured regulatory response. A focused regulation restricting the use of numerical examples that give rise to unrealistic investor expectations is consistent with other regulators' responses to implied messages of typicality, is consistent with the law relative to disclosure of issuer projections, and is consistent with the limited interventionist approach favored by most scholars who have addressed the question of regulation as a method of de-biasing investors. The proposed regulation would prevent the inevitable mistaken inferences that motivate purchases by innumerate retail investors. It also preserves the important policy objective of investor choice, leaving sophisticated investors with structured notes as a menu option when creating their portfolios.

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