Portfolio Management under Judicial Hindsight Bias

Abstract

This paper studies which common legal remedies best mitigate the perverse effects of judicial hindsight bias on risk-taking. We model a risk-neutral agent who invests her risk-averse principal's wealth in a mixture of two assets. One asset is risky while the other risk free. The agent chooses a portfolio according to the prior belief about the investment prospects. After the agent has made a choice and the investment outcome is realized, a hindsight-biased judge rules on the agent's legal liability. The judge rules according to biased, outcome-dependent estimates of prior probabilities. We compare two measures of liability: (i) the expectation-damages rule that places the principal in the same position as she would have been in had the agent complied with her legal duty; and (ii) the compensatory-damages rule that restores the principal to the position she occupied prior to the agent's breach. We find that from the principal's ex-ante perspective, the expectation-damages rule is generally better than the compensatory-damages rule. Intuitively, both rules sanction risk-taking which is excessive from the judge's hindsight perspective, upon observation of a poor outcome. However, only the expectation-damages rule also sanctions risk-taking which is insufficient in hindsight, upon observation of a good outcome. Hence, under the expectation-damages rule, the perverse effects of hindsight judging partially offset each other.