How Nutritious Are Your Investments?

NEW HAVEN – Those labels that you see on packaged foods listing their ingredients and nutritional values had their beginnings in an international scandal and in the efforts by governments to deal constructively with the public outrage that followed. The scandal erupted with the publication in 1906 of Upton Sinclair’s novel The Jungle, a bestseller that detailed the experiences of a Lithuanian immigrant family working in America’s meatpacking industry. The public response to the book’s description of unsanitary conditions in the industry was so strong that the United States Congress enacted the Pure Food and Drug Act – the first law to require labeling of contents on food packages – the very same year. By 1910, according to The Manchester Guardian, “The Jungle Scare” had spread to the United Kingdom, where it had been taken up by “less scrupulous [sic] newspapers of this country,” with “slanderous” and “sensational” claims about the food industry. That may have been true, but the eventual effect was better food labeling laws in the UK, too. Indeed, the scandal set in motion a sequence of laws in countries around the world that today require food labeling to go beyond mere lists of ingredients to include information about the vitamins, minerals, and calories that products contain. These labels are undoubtedly useful to consumers, but it is unlikely that many manufacturers, if given the choice, would have introduced them on their own. That is how regulatory progress is often made. The history of legislative reform is substantially a punctuated equilibrium, with long periods of time during which public apathy prevents any progress, interrupted by scandals that suddenly make progress possible. Entrenched interests (food-processing companies, in the case of nutritional labeling) resist change with all of their lobbying efforts, but public outrage is too strong for them to win. We have to hope that the same kind of outcome will emerge from the financial scandals that have produced public outrage analogous to that directed at the food industries in Upton Sinclair’s day. As was the case then, public outrage today is at a level that might well overwhelm the lobbying efforts of entrenched interests. Indeed, one of the areas in need of such regulatory progress is exactly the same, but has merely moved from food products to financial products. For today we need laws that will require purveyors of financial products to provide the essential information that consumers need. That is the argument of a new book written by the Squam Lake Group, led by Kenneth French of Dartmouth and composed of 15 finance and economics professors, including me. Among its proposals, The Squam Lake Report: Fixing the Financial System recommends that investment products like mutual funds should include a standardized disclosure label analogous to the nutritional labels on foods. The structure of the label should be developed by a committee of academics, regulators, and industry executives with the objective of promoting informed comparison among consumers of investment products. Of course, existing regulations require that a significant amount of information be disclosed in prospectuses for financial products. The label would be designed for those who are less motivated and/or able to read these prospectuses. The group recommends that the standardized disclosure should give the consumer an understandable measure of long-term risk. This might include such measures as the annualized volatility of the inflation-adjusted ten-year returns, and the range of real payoffs that an investment might earn in ten years, including 5th, 50th, and 95th percentiles. Not all investors will be able to interpret even these simple measures of the outlook for an investment. But neither are all consumers of food able to interpret the quantities of nutrients that are shown on nutritional labels. These facts should be there to allow those people who will look at them to do so, and to encourage them to spread the information via word of mouth to others with whom they are acquainted. The standardized disclosure label should not, however, include past returns on investments. This is because most investors overreact to past returns, shifting their money around in a largely futile effort to channel it to managers who can beat the market. This requirement is analogous to that of nutrition labeling, which does not allow listing of nutritional quantities that are not significant in the usual serving size. Moreover, The Squam Lake Report recommends that when an advertisement for an investment product does report a prior average return, it should also include a statement of the uncertainty associated with that return. Including such statements in the disclosure is analogous to the requirement that food labels contain a full list of nutritional factors per serving, rather than merely a featured list that the producer might try to add in order to promote the product. Including such information on financial products would give an enormous boost to the efficiency and efficacy of our financial products in serving customers’ needs. The only reason that such labeling has not yet been required is the same reason that nutritional labels were not required long ago on foods. Public outcry at a time of scandal forced progressive change then; we should hope that it does so now. Robert Shiller, Professor of Economics at Yale University and Chief Economist at MacroMarkets LLC, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. Copyright: Project Syndicate, 2010.