Limits of Disclosure

One big focus of attention, criticism, and proposals for reform in the aftermath of the 2008 financial crisis has been securities disclosure. Many commentators have emphasized the complexity of the securities being sold, arguing that no one could understand the disclosure. Some observers have noted that disclosures were sometimes false or incomplete. What follows these issues, to some commentators, is that, whatever other lessons we may learn from the crisis, we need to improve disclosure. How should it be improved? Commentators often lament the frailties of human understanding, notably including those of everyday retail investors—people who do not understand or even read disclosure. This leads, naturally and unsurprisingly, to prescriptions for yet more disclosure, simpler disclosure, and financial literacy education. We believe that improvements in disclosure will not do much to prevent or minimize the effects of future crises. Indeed, the role of disclosure in investment decisions is far more limited, and far less straightforward, than is typically assumed. To caricature a bit for ease of exposition, the straightforward story is as follows: Read carefully, understand what you read, conduct any additional inquiry you deem appropriate, and then decide—if the security seems good, buy it; if not, don’t. Also, consider that whoever is selling you the security knows more than you do about it and has an incentive to present it more favorably than it warrants. But many investors, even sophisticated investors, do not start with cautious or neutral presumptions about a security and do not carefully read the disclosure to appraise the security on its merits before deciding whether to invest. As the literature extensively discusses, investors may be eager to buy “the hot new thing” that their peers are buying. Why do the peers buy it? One part of the story may be the old and often-told explanation: some investors tired of “boring” returns, saw an opportunity to supercharge their yields, and believed the perennial pitch made for new financial instruments—that they offered more return than risk. But our aim is not to explain what motivated investor behavior; our aim is to point out what did not sufficiently motivate investor behavior. Our argument is not just about the present crisis. Indeed, the complex role that disclosure plays in an investor’s decision as to whether to buy a security is just one example of disclosure’s limits. Those limits reflect the complexity of human decisionmaking. Why should disclosure work? The obvious answers are that better information should make for better decisions and that the specter of disclosure should constrain behavior. But these answers are importantly incomplete. Better information should, in principle, lead to better decisions, but other factors may be far more important. This was the case with disclosure regarding the securities at issue in the financial crisis. We discuss another example as well: executive compensation disclosures