Full Disclosure: Most Risks Hide in Plain Sight

You can lead an investor to disclosure, but you can't make him think.

Jason Zweig highlights some interesting psychology based financial research in this WSJ column.

We still chase returns even when told to focus on low fees (bias from the most recent evidence) and we tend to think the larger a prospectus is the less we need to actually think.

Even if disclosures are easy to think about, investors still may not focus on what matters most. A team of economists, including David Laibson of Harvard, tested whether investors would favor the lowest-cost choice among four index funds if the importance of fees was hammered home in a one-page “cheat sheet.”

The good news: By presenting a simplified emphasis on fees, the researchers tripled the number of investors who favored the lowest-cost funds. The bad news: That tripling brought the proportion up only to 9% from 3%. “We still ended up with a 91% failure rate,” says Prof. Laibson. Encouraged to focus on fees, investors nevertheless fixated on—and chased—past performance.

Disclosure can also backfire. Psychologists Daniel Simons and Christopher Chabris are co-authors of “The Invisible Gorilla,” a forthcoming book explaining why humans so often fail to observe information that should be obvious. Prof. Chabris suggests that the more comprehensive a prospectus seems, the more likely investors are to conclude, “All you need to pay attention to is within the four corners of this document.” That, in turn, may lull investors out of any urge to do further research and exercise independent judgment.

Regulators still should push for better disclosure, but every investor also should rely on a standardized checklist of questions that must be answered before any purchase.