Dan Ariely

In the wake of all this public anger over bankers’ salaries, and within weeks of taking office, Barack Obama is proposing “common sense” executive pay guidelines—at least in companies receiving government money. These measures call for executive salaries not to exceed $500,000; any further compensation could only be in the form of stocks, which can’t be sold until the government is paid back. No doubt this makes us feel better to some extent, but the question is, will it work?

I think not, and here’s why: if we were designing the stock market from scratch and offering people $500,000 a year plus stock incentives, I’m sure we would get lots of qualified people who would kill for this job, and not only for the salary but also as an important civil service to maintain the financial system on which we depend. But this is if we started from scratch, which we are most assuredly not. Instead we’re dealing with existing bankers who are accustomed to millions a year plus millions in stock options. These people have made up, over the years, a multitude of reasons why this is the least that they deserve for their efforts and skills (how many people can admit to being paid much more than they’re worth?). This is a problem of relativity. To these bankers, in view of their “normal” pay, it looks like an offensive and irresponsible offer. My guess is that they will not accept these conditions, or if they do, they’ll find other tricks to pay themselves what they think are “right” and fair wages, which is what they earned heretofore.

What would I have done if I’d been the financial czar in this situation? I would try to turn over a new leaf; incentivize the creation of new banks with a new pay structure; promote the idea that bankers are not greedy bastards but have a crucial social responsibility so that a whole new generation would take this approach and want these positions. The “old bankers” who feel they needed millions of dollars to do their jobs well could try and compete in this new market, but we’d see who actually wanted to bank with them when the alternative is a new bank with more idealistic underpinnings and a better, more realistic, and more transparent, salary structure.

Today I am working on an expanded version of my book — I am going to include some ideas about the stock market and some other random ideas

This American Life had a show a few months ago that I just discovered.  In my mind this is the best description of the financial fiasco I’ve heard.  it is worth listening to.
You can also download the transcript as a PDF.
It is just amazing to see what we end up doing to ourselves.

Irrationally yours

Dan

This week we learned that former Nasdaq chairman Madoff likely swindled investors out of $50 billion – arguably the largest financial fraud ever. And thinking about the gravity of the scam, it occurred to me that Madoff’s scam could be compared in terms of its effects to terrorism. Here’s how:

Consider that there was a time when terrorism wasn’t the big deal that it is now. This was before advances in technology, when terrorists only had recourse to low-level weaponry like stones and knives – which, while harmful on an individual level, are not quite weapons of mass destruction. In time, though, “better” technology came along, leading in turn to “better” terrorist tactics: suicide bombing and the like. Still peanuts, though, compared to what came later: 9/11 planes, bio terror – this is when things really got serious; now even one crazy person can cause a world of damage.

Now, I think Madoff’s case is equivalent in a financial sense. Whereas in the past one person’s monetary misdeeds could affect a handful of people at most, now there’s more at stake: a single person – like Madoff – can cause a whole lot of fiscal damage. And the reason lies in interconnections: when companies began investing with other companies, any fraud can spread and cause damage across many companies.

There’s one other similarity here. What makes terrorism so powerful are its randomness and intentionality: it can strike any time, and you never know when you’ll be a victim and it is done on purpose. Things that we can’t predict, control or at least think we can control make us more afraid. And that’s exactly the case with Madof’s scheme: the investers probably assumed that they were in control and all of a sudeen we all learned that we are much less in control, and that someone can do this to any of us.

If we view the stock market through this terrorism perspective, and we understand that just a few individuals can cause so much damage, it becomes clear that more regulation is needed – we do so much to check people at airports — shouldn’t we use the same level of security for hedge funds?

Dear Irrational,

I am a partner in an asset management company whose purpose is to manage investments for individuals, families, and foundations.  The principles of Predictably Irrational made me think about the effectiveness of each component in our investment process.  My end in mind is: 1) to identify failure ingredients in my investment process and 2) engineer out their removal.
My question follows:

Is ‘falling in love’ with an investment hazardous to one’s financial health? Does ‘falling in love’ with an investment result in predictable behaviors (in me) that lower (or negate) what would otherwise have been an excellent investment performance?

——-

Dear Investor,
We have not done any research directly on this question.  Nevertheless, I suspect that the answer is that we do get attached to investments, that it is not good for us, and that it has the potential to influence our judgment for the worse.

First, regarding ‘falling in love’ with an investment; I think that we would.  What we know about the endowment (ownership) effect is that people tend to fall in love with anything they happen to own (mugs, pens, cars, kids).  Once we have something, it becomes ours and we perceive it as special. As a consequence, we value it more.  I suspect that the same could occur with investments.
On top of that, in the current economy people are feeling like they are in a losing situation (if you don’t feel this way look at your retirement account) but losses in the stock market are not psychologically realized until they are truly realized.  So in people’s desire to hold on to what they have you might suspect that in this economy there is going to be an even stronger tendency to ‘fall in love’ with an investment.
Why is this not good for us?  Because the expected value of investment options are about their future potential and the past is just water under the bridge.

The good news is that you can do something about it, and advise your clients to do the same.  Imagine that at the start of every month you don’t look at your portfolio and instead you design your strategy and market positions as if you started from scratch.  The idea is that if you start from scratch you have a clean past with no commitments to past decisions.  I am not sure if the ‘falling in love’ with an investment sentiment will go away completely but I think this way it will be less powerful.
Irrationally yours
Dan

From the NYT op-ed
BY withholding bonuses from their top executives, Goldman Sachs and UBS may soften negative reaction from Congress and the public if their earnings reports in December are poor, as is expected. But will they also suffer because their executives, lacking the motivation that big bonuses are thought to provide, will not do their jobs well? Read the rest of this entry »