This blog post examines how behavioral economics reveals the human irrationality and psychological biases overlooked by traditional stock price reflection theory, exploring what new insights it offers for investment decisions and market interpretation.
Today, economics is also actively utilized in making legal judgments. One such case is “Basix v. Levinson,” where a ruling was made primarily based on economic theory in a shareholder class action lawsuit. Basix publicly denied a merger with Combustion during the process, but ultimately merged with Combustion. Subsequently, some shareholders who had sold their stock before the merger announcement filed a class action lawsuit, claiming they suffered significant financial losses due to Basic’s denials. After heated debate between the plaintiffs and defendants, the U.S. Supreme Court ruled in favor of the plaintiffs in 1988.
At the time, economics was dominated by the traditional theory that “people invest in stocks with the company’s true value in mind, and all information about that true value is reflected in the stock price, so the true value and the stock price are consistent.” While there was debate over whether this theory held true in reality at all times or only approximately over long periods, its basic premise gained broad scholarly agreement. The Supreme Court held that this theory could be applied to legal judgments if the stock market was open to all. In such a situation, it could be assumed that people made investment decisions based solely on stock prices. Therefore, the Court found there was sufficient reasonable basis to presume that Basics’ failure to disclose the merger process caused investors to make erroneous decisions, resulting in financial losses.
This ruling subsequently became the standard for judging class action lawsuits related to false disclosures. This ultimately signifies that economics provided a solid rationale for resolving the difficult problem of how to prove damages caused by false disclosures in disputes concerning the disclosure of crucial information about a company’s true value.
However, there are also numerous arguments that weaken the legitimacy of traditional theory. First, Keynes’ assertion that “the real interest of stock investors lies not in the value of the firm, but in how much they can sell their shares for” can be interpreted as a critique that shakes the fundamental premise of the traditional theory. Furthermore, starting in the early 1980s, more direct challenges to the traditional theory emerged. For the traditional theory that stock prices reflect true value to hold, there must be constant interaction between buyers and sellers—those focused on true value and those who are not. For this to be possible, professional stock investors concerned with true value must have opportunities to profit from trading against less-informed investors based on conflicting expectations about future stock price movements. However, the opportunity to profit from such arbitrage only arises when stock prices and true value diverge, at least in the short term. This can be interpreted as another weakness of the traditional theory.
Behavioral economics, recently gaining renewed attention in the economics community, offers a more scathing critique of the problems in traditional theories regarding the information transmission mechanism in stock markets. It actively incorporates findings from psychology to present a picture of human behavior that diverges from traditional views. According to this perspective, humans are beings who overestimate their ability to control their future while excessively fearing being left behind when others succeed. When these irrational traits manifest in the stock market, even professional investors engage in paradoxical behavior that widens the gap between stock prices and true value. Even if they are convinced stock prices are detached from true value, they cannot precisely predict when prices will align with intrinsic worth. Consequently, rather than betting against the majority, they choose to ride the prevailing trend, confident they can exit just before the current trend reverses.
If the resolution of legal issues actively incorporates research findings from various fields of economics that have received relatively little attention until now, the Supreme Court’s ruling is likely to face criticism that it not only lacks a solid theoretical foundation but also fails to properly reflect its original intent of protecting investors concerned with a company’s true value.
