If you were faced with two investment opportunities:
- one involving the purchase of a stock at 1/1000th of the asking price, and
- the other involving the purchase of a stock with a possible future obligation to pay 2000 times the original unit value of your investment, which one would you take?
Obviously, the first one would be almost irresistible; the second would seem quite dubious to anyone. It came as a shock to many mom and pop investors that, in the case of their BrisConnections holdings, the two options were identical. As reported in the Sydney Morning Herald this week,
BrisConnections stapled units were sold in a initial public offering last July, with investors paying the first of three $1 instalments at the time.
They were then required to pay two further instalments, one this month and another in January 2010.
But many shareholders sold out of the stock after it was listed, with the units closing at 41 cents on the first day of trading.
They had plunged to 0.1 cent by October and have remained around that level ever since.
Many retail investors bought the units thinking they were getting a bargain, without realising that they would be required to pay a further $2 on each unit, making themselves liable for further payments up to 2000 times the value of their investment.
To borrow the words of Richard Thaler and Cass Sunstein, authors of the book Nudge, this is a case of poor “choice architecture”. One of the main points found in the book is that although many of us would like to think of ourselves as rational decision-makers, we are often primed to make foolish choices by of the way solutions are framed.
As behavioural economists point out we are (aside from being rational beings) subject to human frailties that our reasoning often gets confounded by complexity. What a layperson perceives as a perfectly reasonable choice upon closer scrutiny often turns out to be misinformed. Discounting this very nature of our thought processes may lead to a poor design of “nudges” or the prompts that are aligned to the way our brains are wired preventing us from perceiving a situation correctly.
In the case of BrisConnections, investors thought they were buying into a project which had a compelling business case with an implicit state guarantee at a huge discount. They failed to assess the risk of contingent liabilities. Yes there were public disclosures but most do not read the fine print when accepting an offer is only a mouse click away. Following Nudge principles, a simple prompt after the person has pressed “accept” warning them of the possible value of their contingent obligations would have alerted many to the dangers of proceeding.
