A Legal Analogy

Fundamentals of Market Investing by Adam J. McKee

In criminal law, the cases of the Supreme Court of the United States are filled with references to the “reasonable man.”  What is reasonable is impossible to define in objective terms, because reasonableness is situational.  What is reasonable under one situation may not be reasonable under dissimilar circumstances.  The “reasonable man” test, despite its sexist overtones, provides a useful tool for determining the reasonableness of a person’s actions.

The Court has also recognized that the idea of “reasonableness” can be either subjective or objective, depending on the nature of the underlying legal question.  When we use a subjective test, the jury must infer what that particular person thought was reasonable under the circumstances as he or she saw them at the time of the questionable act.  When the Court refers to a standard of objective reasonableness, we bring in the reasonable man as a benchmark.

The Courts have established that reasonable people are not risk seekers, nor are they overly risk-averse.  They are people of “ordinary prudence.”  Further, our sense of fairness usually dictates that we judge such actions based on the facts as the person believed them to be.  We are willing, in other words, to forgive transgressions arising from a mistake of fact, so long as the mistake was reasonable.  You cannot ignore salient facts, but if you don’t know that they are there, then the legal system will potentially forgive you for not knowing and acting on bad or complete information.

The idea of a fair and efficient market is very similar to an assumption that on average, investors are reasonable and of ordinary prudence.  This legal aside provides us with a framework to determine if a potential problem for both participants in the legal system as well as participants in the markets exists.  Can a person be so prudish (risk averse) as to rise to the level of unreasonableness?  Imagine a police officer that never believes that he has enough evidence to make an arrest.  Overzealous officers that go around arresting everyone without probable cause are obviously unacceptable, but criminals would soon control society if no one was ever arrested.

Society needs officers that can objectively determine the sufficiency of the available evidence and act in accordance with the law despite the risk of being wrong.  This is the requirement for a police officer to be successful.  For the individual investor to be successful, she must assess the sufficiency of available information and make reasonable yet prudent investment decisions.

Just as taxpayers would feel that an officer that never makes an arrest is unsuccessful, we must consider ourselves unsuccessful if we never make a real profit from our investments.  As the Constitution requires that an arrest be based on real evidence that amounts to probable cause, we must make investment decisions based on real information that leads us to conclude to our own standard of risk that an investment will make us money.  Obviously, the quality of evidence becomes of critical importance to the outcome, regardless of whether we are talking about arrests or investments.

The Court has recognized that the experience and training of police officers gives them an edge over the public when determining if a crime is afoot.  Similarly, the investor with experience and knowledge of economics and finance has an edge over most market participants who are not full-time money managers.  From this vantage point, professionals will view nonprofessionals as acting unreasonably because of a want of knowledge, not a defect of character, or a quirk of abnormal psychology.

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Last Updated: 6/25/2018

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