Die Zeitschrift für stud. iur. und junge Juristen - Iurratio

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tively enacting of legislation, whereas the incorporating of financial
ideas to legal policy can contribute importantly to the maximization
of market efficiency and to the decrease of transactional costs.
The interaction of law and economics constitutes an important scientific
field under the term law and economics (with great resonance in the
United States), which through the years finds more and more devotees
all over the world. It is crucial to mention that over the past decades
the proposal and the interpretation of legal rules not only by the adherents
of law and economics but also by the legislators and the judges
are based on the traditional economic approach and the rational choice
theory. This means that the starting point of the legal thought has been
the concept of a rational human being, who reacts predictably in order
to maximize his profit. But as Behavioural Economics evolve to a
scientific movement with a solid and reasoned basis and acceptance to
the academic community questions raise, whether the existing rules
should be modified in a way that takes into account the new findings.
This paper aims exactly at showing the way in which the findings of
Behavioural Finance should influence the structure and the goals of
legal policy. More specifically, it is examined whether and to what extent
the dispute of the traditional economic approach should lead to
the enacting of new legislation, which would focus on the protection
of market participants.
B. Explanations provided by Behavioural Finance
I. Heuristics and Cognitive Biases
In the investment practice there is a number of examples, which cannot
be explained by the classical financial theory and the conception
of the homo economicus. Behavioural Finance is trying to propose
alternative explanations of these behavioral anomalies by using the
theoretical apparatus of cognitive psychology and starts off at the
point that market participants have the tendency to make decisions
based on heuristics. This term refers to experience-based techniques,
which people use in order to find a quick and often simplified solution
to a problem without trying to gather and evaluate all relevant
information 9 . As it is not a subject of this essay to examine all possible
forms of heuristics rules that have been observed and studied, it will
be limited to those, which have a notable impact on the way people
make financial decisions.
Such a notable impact on the decision making has the availability
heuristic, a mental and often unconscious procedure based on the
ease of recall and retrieval of certain facts. This means that the probability
and the importance of an event is determined by the degree
to which instances of that event are vivid or simpler available in memory.
As Tversky and Kahneman report “if you can think of it, it must
be important” 10 . The effect of availability on the economic procedure
has been subject of research 11 with writers to emphasize that positive
stock price reactions to recommendation upgrades are stronger when
they are combined with positive stock market index returns. This is
indicative of the investors’ tendency to acquire stocks with high media
coverage or significant price fluctuations and on the contrary to
avoid those from which they have a negative trading experience.
Another model of human behavior, which influences the procedure
9 For a more analytic view of commonly used heuristics see Pólya, in: How to Solve it: a New Aspect
of Mathematical Method, 1 st ed.
10 Tvesrky, Kahneman, in: Cognitive Psychology 1973, 207 (208).
11 See for instance the article of Kliger and Kudrayavtsev, where the aspects of outcome availability
and risk availability are explained, Kliger, Kudrayavstev, in: Journal of Behavioral Finance 2010, 50.
followed to reach a solution and is therefore related to the availability
heuristic is the bounded rationality 12 . According to this idea, people
make irrational choices because of their tendency not to gather all
relevant information, as they seek a satisfactory solution rather than
an optimal one. In practice, due to the fact that market participants
and specifically non-sophisticated investors do not have unlimited
resources and unlimited time to find the better solution or even to
evaluate the given solutions they simplify the procedure of decision
making by choosing to ignore the risks which they are exposed to.
This is among others the reason why investors do not read the disclosure
documents when they reach a decision, but they choose to trust
their own limited knowledge even if they have indications that they
should examine profoundly the offered financial products.
Psychologists have also observed the tendency of people to rate the
probability of an event based on the degree of similarity to other familiar
situations. The representativeness heuristic is defined by Tversky
and Kahneman as “the degree to which [an event] (i) is similar in
essential characteristics to its parent population, and (ii) reflects the
salient features of the process by which it is generated” 13 . The categorization
of a situation, the effort to find common points and the formulation
of rules for the evaluation of probabilities on the base of ostensibly
relevant events forms an easy computation. When a person
reaches a decision by using this form of thought the truly important
facts-such as the base rate-are ignored to a significant extent. More
specifically, the result of representativeness heuristic on the investment
practice is that market players invest their portfolios by assuming
that future patterns will resemble past ones. This means that
they are principally influenced by the recent outcome of securities 14 .
Another problem that occurs when investors wrongly believe that the
more representative fact is also more likely is that they neglect the
sample size and they do not take in mind the law of large numbers 15 .
The related model of Gambler’s Fallacy describes the belief that a casual
event will take place when repeatedly deviations from expected
have already occurred. The representativeness heuristic influences
not only directly the investment’s practice, but also indirectly as it is
observed that some investors choose investment advisers with poor
long-term records just because they have shown a recent short-term
success 16 . The deviation from the expected behaviour in this case
consists of not taking account of the indicative for the advisers’ effectiveness
facts, but risking their investments due to a one and only
successive decision.
Furthermore, a number of serious behavioural anomalies can be
caused by the tendency of individuals to overestimate their abilities.
While confidence represents the trust in the human abilities,
overconfidence implies a subjective, optimistic assessment of one’s
judgment ability or control over a situation. Overconfidence has
been characterized as “the most pervasive and potentially catastrophic
of all the cognitive biases” 17 which influences the human
thought. It is not only that acting with overconfidence can lead
to obviously irrational choices, but also that the examined way of
thinking influences the overwhelming majority of people. More
specifically, as a 2006 study indicates 74% of the professional fund
managers evaluated their performance as above average, whereas
12 Selten, in: Bounded Rationality: The adaptive Toolbox, 1 st ed., page 13.
13 Tversky, Kahneman, in: Judgment under uncertainty: Heuristics and Biases, 1 st ed., page 33.
14 Linciano, in: CONSOB 2010, 3 (7).
15 As Uhlig explains according to the law of large numbers (LLN) the average of the results of an
experiment which had been performed several times will be close to the expected value and will
become closer as more trials are performed, Uhlig, in: Economic Theory 1996, 41.
16 Prentice, supra note 7, 1471.
17 Plous, The Psychology of Judgment and Decision Making, 1 st ed.
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