CONTACT: GEORGE McCRORY
100 Old Public Library
Iowa City IA 52242
(319) 384-0012; fax (319) 384-0024
Editors note: For additional comments on the study, contact professor
Robert Forsythe at (319) 335-0865 or professor Thomas Rietz at (319) 335-0856
UI study supports SEC actions to control bogus investment information
IOWA CITY, Iowa -- If you hear about a hot stock tip online, be wary
of the source. If you can't easily verify the information, the source is
probably exaggerating, according to a recent University of Iowa study.
The study found that gullible investors tend to pay more for a stock,
believing in false claims made by sellers intent on increasing the value
of their assets.
"Potential investors need to be extremely skeptical of on-line advice.
Information that can't be verified through independent sources should
not be believed," said study co-author Robert Forsythe, senior associate
dean of the UI College of Business and Cedar Rapids Professor of Business.
The study supports the 23 anti-fraud Securities and Exchange Commission
enforcement actions recently filed against online stock promoters who allegedly
provided false company information via online chat rooms, bulletin boards
or "spam" email messages. In some cases, the promoters also were
charged with not disclosing payments they received to promote stocks.
"Our results suggest that regulators' fears about the effect of
unrestricted communication on uninformed investors may be well founded,"
said UI finance professor Thomas Rietz. "You can not verify the identity
and profession of the people in online forums and may not be able to verify
their statements. Ordinary investors may be taken advantage of, since
they can not tell whether the investment advice comes from other enthusiastic
investors, or if it is outright fraud by interested parties."
Forsythe and Rietz worked with University of Michigan business professor
Russell Lundholm on the paper, "Cheap Talk, Fraud and Adverse Selection
in Financial Markets: Some Experimental Evidence," which was recently
accepted for publication in The Review of Financial Studies.
The researchers set up an experiment using UI business students who
represented buyers and sellers of investments. Like the online stock bulletin
boards, the buyers received information from sellers on computer screens,
but couldn't verify the accuracy of these reports.
The experiment involved three different investment scenarios using real
money as a payoff for correct decisions. In all the scenarios the sellers
knew the true value of the investment, while the buyers only knew the chances
that the investment was good, average or bad. In some cases, sellers could
talk to the buyers and exaggerate or even lie. Buyers only knew when sellers
were allowed to lie, not whether they would actually lie.
As a baseline, the researchers used a "gag rule" prohibiting
sellers from talking to buyers. In a "cheap talk" scenario similar
to an unregulated market, sellers could make any statements, even fraudulent
ones, to buyers about the investment. In an "anti-fraud" treatment,
the researchers imposed an anti-fraud rule where the sellers could exaggerate,
but not provide fraudulent or false statements.
They found more trades occurred in the unregulated market than in other
settings, but at the expense of the buyer.
"But when we added the anti-fraud rule to sellers' communications,
the markets still operated efficiently, but the sellers didn't get rich
at the buyers' expense," Forsythe said.
When the buyers and sellers switched roles in the "cheap talk"
scenario, the researchers observed the same outcome -- the crafty sellers
benefited from the gullible buyers. Sellers continued to be deceptive,
while the buyers were still not skeptical enough about the statements they
heard. Subjects who were more inclined to lie about investments as sellers
were also more likely to be influenced by bogus information when they became
"They believed they were the only ones capable of dishonesty. For
lying to be profitable, sellers must believe that others will be taken
in by the false disclosures," Forsythe said.
The study showed that uninformed investors can be easily deceived. As
one researcher observed, "There's at least a half a sucker born every