Chapter 10: the power of price

I am teaching today in class about self control problems, and approaches to regain self control.  Here is a story of Buffett and his attempts at self-control:

Even the most analytical thinkers are predictably irrational; the really smart ones acknowledge and address their irrationalities. We find a great example in Alice Schroeder’s “The Snowball: Warren Buffett and the Business of Life.”

Warren Buffett is a numbers-driven investor whose life choices and business decisions would make the vulcan Mr. Spock seem over-emotional. A teenage horse handicapper who grew up into a deep reader of Moody’s and Standard and Poor’s reports, Buffett is the archetypal quant: a data-processing, information-consuming, hard-thinking, analytical machine. His ability to outperform the market by basing his decisions on hard data and on an uncanny understanding of business fundamentals earned him the moniker “Oracle of Omaha.”

Buffett’s success as an investor required not only deep analysis of financial documents but also a large measure of self-control to avoid getting caught in market bubbles and panics. Buffett’s rule “buy when everyone else is selling, sell when everyone else is buying” requires enormous self-assurance to execute.

And yet, even the Oracle of Omaha is not immune to the allure of irrational behavior. He is what Behavioral Economists call a sophisticate: someone who understands his irrationality and builds systems to cope with it. (The other types of people are the “rational,” who never deviates from optimal behavior, and the “naif,” who is unaware of his irrationality and therefore doesn’t do anything to address it.)

Uncommon a person as he was, Buffett had a very common concern: he feared gaining too much weight. Rational agents don’t gain weight because they always consider all the possible consequences of all actions. Naifs plan to start their diet tomorrow.

But Buffett — who breakfasted on spoonfuls of Ovaltine — understood his predictable irrationality: people eat without consideration for the long-term effects; that’s why they gain unwanted weight. Being a pragmatic person, he decided to curtail overeating with a commitment device.

He gave unsigned checks for $10,000 to his children, promising to sign them if he was over target weight by a certain date. Many people use commitment devices to try to keep their weight down, but Buffett’s idea had a big flaw: his children, spotting a rare opportunity to get money from the notoriously frugal billionaire, resorted to sabotage. Doughnuts, pizza, and fried food mysteriously appeared whenever Buffett was home.

In the end the incentives worked: even with his children’s sabotage, the Oracle kept his weight down, and his checks went unsigned. But had he been purely rational, no commitment device would have been needed.

These days when there are lots of financial related scandals and cheating this topic might be particularly relevant.

I am not sure it is the best talk I ever gave, but if you have 17 min to spare…

Take me to TED

The first chapter of the Bernie Madoff fiasco has come to a close, with Madoff pleading guilty to 11 charges of fraud yesterday.

Madoff’s massive Ponzi scheme was horrific on many levels. But while we watch the next phase of the scandal, it’s important to ask: What lessons are we going to learn from this? I can see three lessons that relate to my work studying human irrationality — and in particular, some non-useful lessons we might learn.

One lesson that individuals and foundations are likely to take from the Madoff scandal is that in addition to diversifying their portfolio across several investments (stock, bonds, equity, cash), they also need to diversify their investments among several advisors. While the idea of diversifying among advisors has some merit — and it could reduce the exposure risk of another Madoff scandal — it will also make the task of managing portfolios much more difficult and much less efficient. Imagine that you have $1,000,000, split among four advisors. You will need a whole new level of coordination among them so they can have the right amount of cash, bonds, stocks etc., across all of your assets.

And I think that people will begin to over-diversify across investors. Why? Because when we have one large and salient instance in our minds, it can be so powerful that we overemphasize it. This same effect is very apparent in what we call “the identifiable victim effect,” and it is the reason that we overemphasize the risks of a shark attack, and underestimate the risks of riding a bike without a helmet. In general, what we find when there’s one single vivid event is that people overweight it — we focus on it too much. So that’s the first lesson: We’re going to learn from the Madoff scandal, but we are going to overdo it.

Another non-useful lesson that I think we will adopt is to start searching with more vigor for other bad apples. On one hand, it is clearly important to prevent more Madoffs, but at the same time I worry that as a consequence of searching for bad apples, we won’t pay enough attention to other financial behavior that might not be as badly wrong but that can actually have larger financial consequences.

In our research on dishonesty, we found that when we give people the opportunity to cheat, many of them cheat by a little bit, while very few cheat by a lot. In our experiments, we lost about $100 to the few people who cheated a lot — but lost thousands of dollars to the many people who each cheated by a bit. I suspect that this is a good reflection of cheating in the stock market, where the real financial cost of the egregious cheating by Madoff is actually a tiny fraction of all the “small” cheating carried out by “good” bankers.

The risk here is that if we pay too much attention to chasing bad apples, we might pay too little attention to the situations where the small dishonesties of many people can have large consequences (such as paying slightly higher salaries to cronies, making small changes to financial reports, doctoring documents, being slightly dishonest about mortgage terms), and in the process neglect the real economic source of the trouble we are in.

A third bad lesson that I think people will take from this concerns the way we define acceptable levels of cheating. In a study that may parallel Madoff’s egregious dishonesty, we again gave the participants the opportunity to cheat, while solving a puzzle quiz — but this time we hired an actor. This actor, posing as a fellow participant, stood up at the start of the session and declared that he had solved all the puzzles. Now the question is how his behavior would influence the other participants in the room — the ones who were watching him.

What we found is that when the actor wore a plain T-shirt, which made him part of the student group, cheating increased. On the other hand, when the actor wore a T-shirt of the rivaling university, cheating decreased. What this means is that when someone who is part of our own social group cheats, we find it more acceptable to cheat, but when people who are not part of our social group cheat, we want to distance ourselves from these people and cheat less.

Madoff was part of the financial elite — part of an in-group of our financial leaders. Think of all these people who were in his house, who knew him well. So now, when other people in this circle see him cheating, think about the long-term consequences: Would these other people in this financial industry now be more likely to take the immoral path? It doesn’t have to be another Ponzi scheme. It just means that, now that they have been exposed to this extreme level of dishonesty, they might adopt slightly lower moral scruples. Maybe they will start not letting their clients know exactly what they own and what they don’t own, or change a little bit the interest rate that they’re charging them … I don’t think that those in his circle will necessarily become more Madoff-like people, but I do suspect that they will get a substantial relief from their moral shackles. Sadly, that’s his legacy.

So, Chapter One of the Madoff scandal is over, but I worry that the negative downstream consequences of this experience are just starting …

In case you live in NY and have nothing to do on 3/16 at 6-8 PM

I am going to give a short talk on the stock market from the perspective of behavioral economics — on the floor of the NY Stock Exchange

This is hosted by George Washington University, but everyone is invited and there is going to be some free food — so if you have nothing better to do ….

http://www.alumniconnections.com/olc/pub/GEW/events_luther/event_order.cgi?tmpl=events&event=2220180.0

Irrationally yours

Dan

Have a look at this!  it is a rather nice account of the credit crisis

A 70-year-old, extremely wealthy widower, shows up at the Country Club with a beautiful and very sexy 25 year-old blond who knocks everyone’s socks off and who hangs over Bob’s arm and listens intently to his every word.

His buddies at the club are all aghast. At the very first chance, they corner him and ask, “Bob, how’d you get the trophy girlfriend?” Bob replies, “Girlfriend? She’s my wife!” They’re knocked over, but continue to ask, “So, how’d you persuade her to marry you?”

“I lied about my age,” Bob replies, “I told her I was 90!!”

Also see this:

On the way to give a talk at Caltech

I had a plan of having one video per chapter — and I still have this plan.  So far we are at chapter 9