This blog post continues our series on complex investments.
Image: Bertrand Russell
“To a mind of sufficient intellectual power, the whole of mathematics would appear trivial, as trivial as the statement that a four-footed animal is an animal.”
- Bertrand Russell
People naturally believe other people know what they know. This is known as “the curse of knowledge”, and was originally observed by psychologists and then economists who noticed that individuals in transactions often didn’t take full advantage of their private knowledge.
In 1990, Elizabeth Newton, then a Ph.D. student in psychology at Stanford, designed a simple experiment that brilliantly demonstrated the curse of knowledge. The experiment involved two subjects: one designated a “tapper”; the other a “listener.” The tapper would tap out the rhythm of well-known songs on a table. Some of the songs included “Happy Birthday” and other instantly recognizable tunes. The listener would try to guess what song was being tapped out.
The listeners were only able to discern 2.5 percent of the songs. However, before the experiment began, the tappers predicted the listeners would be able to guess 50 percent of the songs being tapped out. The tappers were off by a factor of 20.
The reason for the 20x disparity is that the song being tapped out seems so obvious to the tapper. They can hear the melody in their head as they tap it out and assume the listener can also hear it. This is the curse of knowledge. However, the listener doesn’t hear the melody, they only hear the unconnected taps. Without the melody, the taps have no context and were shown to be meaningless 97.5 percent of the time.
This phenomenon is on proud display in investment disclosure documents. In these, securities lawyers have drafted them by writing out melodies they know by heart from being immersed in their singing for decades. Meanwhile, their readers, who are untrained in the stylized incantations of securities law, hear nothing but discordant notes.
A review of a typical sentence from an auction rate security disclosure document is instructive:
The Issuer and ALL Student Credit may, upon receipt of a Credit Confirmation and in the case of ALL Student Credit the consent of all the Holders of the Senior Series IV-A-6 Bonds and the Series IV-A-13 Bonds, issue Additional Bonds in the future on a parity with Senior Bonds, Senior Subordinate Bonds (if any), Subordinate Bonds or Junior Subordinate Bonds then Outstanding.
Remarkably, this sentence uses 12 defined terms. If the reader does not have command of all 12 terms, she won’t understand the sentence. The Term Supplement and the Offering Memorandum from which this sentence originates is 184 pages long. In order to understand this lone sentence, much, if not all, of those 184 pages would have to be mastered.
The writer, however, does have command of all 12 defined terms. In fact, from the writer’s perspective this sentence is fairly simple and self-evident. These terms (both the defined terms and the deal terms) are common in auction rate security structures.
The lawyer who drafted this sentence is Bertrand Russell’s “mind of sufficient intellectual power”, and to that lawyer, understanding the sentence is trivial. The problem is that when writing the disclosure document, all their hard won intellectual power and facility with these terms of art become a curse.
They write sentences like the above because to them, there are no defined terms. All the terms are self-evident, like cat or tree. Indeed, they may take pride in the artful construction of such sentences.
Thus the curse of knowledge, which starts out as a curse on the writer becomes a curse on the reader. The writer’s unconscious assumption that everyone shares her knowledge becomes a very real curse on readers that makes them unable to understand what has been written. This would be a good setup for a sitcom if investment disclosure documents weren’t one of the ways investors are supposed to be protected.
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 Samuel K. K. Blankson; “The Einstein Theory of Space-time Without Mathematics”, (Lulu Enterprises, UK) 2005; 38.
 Access to Loans for Learning Student Loan Corporation, Student Loan Program Revenue Bonds, Term Supplement to Attached Offering Memorandum; CUSIP 00433TAA1; October 11, 2007; TS-5; Available at: http://emma.msrb.org/MS264555-MS239863-MD468187.pdf; Accessed on November 19, 2014.