The Investor Confidence Game

Recent reports of massive accounting frauds at some of the nation's largest and most respected companies have provoked calls from policymakers and business leaders for market reforms to shore up investor confidence. Nevertheless, the phenomenon of investor confidence has received relatively little formal study. Current legal scholarship tends to assume, with little discussion, that investors have "confidence" when they have information that assures them that the incentives provided by the law and by the markets are adequate to constrain corporate insiders and securities professionals from shirking, stealing, and other forms of opportunistic behavior. This "rational expectations" approach also implies that, in the absence of such assurance, investors protect themselves from others' opportunism by refusing to invest in the market in the first place. This article argues that the phenomenon of investor confidence can be understood far better if we assume not that investors have rational expectations, but that they have what economists call "adaptive expectations". Individuals with rational expectations predict others' behavior by focusing on their external incentives and constraints. In contrast, individuals with adaptive expectations predict others' behavior (including possibly the behavior of such an abstract "other" as the stock market) by extrapolating from the past. Adaptive expectations consequently permit trust, meaning a belief that another will behave in a cooperative and trustworthy fashion simply because he or she has behaved trustworthily and cooperatively in the past. The article argues that there is substantial reason to believe that adaptive expectations-based trust is essential to a well-developed public securities market. It reviews experimental studies that shed light on how trust can be developed and how it can be destroyed. Finally, it considers some of the policy implications that flow from an adaptive expectations model of investor confidence. One of the most important is that trust may be subject to "history effects." If an individual or institution has behaved cooperatively in the past, trusting investors tend to assume that that institution or individual will behave cooperatively in the future - even if incentives change so that cooperation is no longer advantageous. Conversely, trust that has been abused tends to disappear, and it can be slow to return even when the problems that led to its abuse have been corrected. This second observation carries pessimistic implications for lawmakers' ability to restore investor confidence quickly through legal reforms after that confidence has been eroded.