Suppose Charles Ponzi, the late, great salesman, tells you about his new company that just went public. He explains that it’s the greatest thing since sliced bread. You, not knowing he is also the late, great grifter, believe him and buy 100 shares for $10 each. The market adores him and the stock soars to $20. You’re proud of your investment. The problem is the company is only the best thing since pumpernickel bread and the stock collapses to $5 when people find out.

You sue Ponzi for fraud. You plead your case in court, explaining that if Ponzi hadn’t made false statements, the stock wouldn’t have cost $10 when you bought it. Ponzi, in response, argues that his statements had nothing to do with the loss, which was instead caused by Herman Cain’s tax plan.

You are sure that Ponzi’s misrepresentation caused you to lose money, but aren’t exactly sure how to prove that in court. You might argue that the market, soulless and omnipresent, absorbs all publicly available information to establish a price. But here, because Ponzi misrepresented certain information, the market set the wrong price for your stock. So when the true information was revealed, the price was corrected, or fell, to $5. But does this really prove that he caused the loss? And how do we know that he caused the full reduction in price?

This hopefully shows the difficulty with loss causation. How does one really prove that another’s misrepresentations directly caused a loss in money? We’ll explore the question further next week.

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