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

A few days ago there was lots of happiness and excitement in the street and you must have wondered what was the source of this excitement.

Well, it was the publication of Peter Ubel‘s new book on behavioral economics — Free Market Madness

To celebrate, here is a web interview with Peter and you are all welcome to join in on the conversation.

Dan: You are a physician writing a book about politics and behavioral economics.  Not to get all Blagojevichy on you, but what the f%^# qualifies you to write about this topic?

Peter: I am a big fan of yours too!

Dan: But seriously.

Peter: I conduct research on the irrational forces that influence people’s medical decisions.  In addition, I take care of patients in clinic every week whose health problems arise, in large part, from their own decisions and behaviors — people with diabetes who cannot lose weight despite their best efforts, smokers who can’t kick the habit despite covering their body with nicotine patches.

Dan: What does that have to do with politics?

Peter: It means that when we leave people to fend for themselves in the free market, we can predict that they will hurt themselves by making bad decisions.  Starting from this perspective I try to expose the unconscious forces that influence our behaviors.  And then I try to show people what that means for the kind of debates we have about whether unfettered free markets deserve some, um, fettering.

Dan: All this looks a bit too general to me.  Can you give me an example of one disease, one mistake that patients make, and one policy recommendation?

Peter:  Diabetes.  We have an epidemic of adult onset diabetes in developed countries now, because people are gaining so much weight.  And the obesity that causes diabetes is a direct result of the market:  capitalism has spurred on innovation in food production, so that people now can eat tasty, calorie dense food without having to spend much time preparing or cleaning up the food (open the bag of chips, insert in mouth, yum . . .).   

What’s the mistake here?  Well, people’s appetites are influenced by unconscious forces. Change the size of my dinner plate and I’ll eat 24% more calories; tell me the food is made of “healthy fat,” and I’ll tell you it doesn’t taste good (even though, as experiments have shown the same cracker will “taste great” if I convince you it is made out of unhealthy fat.)  How much food we eat, then, and how that food tastes is far less rational than most of us believe.

Dan:  So, does this mean that the fault is with capitalism and innovation in food production?  And if this is the case what policies would you try to implement to overcome this problem?

Peter:  We need to experiment on a whole slew of policies to combat obesity: New York is requiring restaurants to post calories on their menus, a good start, but one that is likely susceptible to biases.  For example, if I was trying to sell Big Macs now, I’d add a new line of “Bigger Macs”–add a couple slices of bacon, 3 more kinds of cheese.  I’d proudly label this new burger’s calories: 50% more than the original Big Mac.  And I’d expect two things to happen:  first, some people would be drawn to this meal — risk takers, contrarians, Homer Simpson wannabees and so on; second, most people would not want this new burger, but they’d look at the Big Mac and think, “Wow, that burger is pretty darn healthy!”

I’d like to see someone try to label unhealthy food with emotive pictures, signaling that people should consider trying out another entrée.  Maybe a profile of people in varying stages of obesity?  

Ok, maybe some other symbol.

Dan: Your book is actually not much about medicine and medical related mistakes and it is largely about individuals and markets.  It seems that you believe that markets are efficient in the way that they operate, but that the outcome they arrive at is not optimal.  Can you explain this?

Peter:  Hmm, efficient wouldn’t be on my short list of words to describe markets.  Efficient sounds so uncontroversially good.  

I am a fan of capitalism. Very happy I grew up in the USA rather than the USSR.  But that doesn’t make capitalism, or free markets, perfect.  Look at all the people who bought mortgages they shouldn’t have bought, or SUVs that they mistakenly thought were safer than other cars.  (SUVs are more dangerous than minivans and even sedans, because they have a nasty habit of rolling over–very inconsiderate of them!)

Our brain can tell us that a long commute isn’t a big deal, or an adjustable rate mortgage isn’t a big risk, and the market efficiently provides us with suburban homes and fancy mortgage packages.  That doesn’t mean we picked the right home at the right price.

Confession: I live in the suburbs (barely), drive a sedan (because I don’t feel manly enough for an SUV), based the last decade of my savings and spending behavior on the assumption that my stock holdings (retirement accounts in mutual funds) would grow at 10% a year, and that my house’s value would grow faster than inflation.

At age 46, I have lots of time to rejigger my retirement plans.  But my fingers are crossed that my kids don’t get into college!!

Dan: So now that we know we should not take any advice from you, what are you hoping is the main thing that readers will learn from your book?

Peter:  This may be too personal but if they can go home at Christmas armed with good arguments to take on their insanely libertarian older brother, who really does think the market can solve all the world’s problems (“we need more free market in medicine, schools . . .”), then I will be happy.  

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?

Recently I had an interesting experience being poor. It didn’t last too long but it was quite distressing and I learned how difficult this is. The story is as follows. I was out of the country for a month and during that time my car insurance expired. When I got back I called my insurance agent and I asked them to renew my policy. “No, no, no, ” they said, “If your insurance has elapsed you can’t do it over the phone and you have to come to our office in person.” Well at that time I was living in Princeton and my insurance agency was 300 miles away in Boston.  So I took the train up, got to the insurance office on time and I was ready to hand them a check and renew my insurance.
Well, here again, I was wrong. It turns out I could not do it by check. The insurance company would not take a check from me because, after all, I have shown I am financially irresponsible. “Will a credit card do?” I said. “Of course not. Only cash.” The limit I can take out with my ATM card is $800 a day and the insurance was almost $3,000 (needless to say they also increased my premium). So I could not solve it this way. “Luckily” the insurance agent had a solution at hand that was designed for this very particular problem.  There is another company they told me that would finance my insurance fee. Interestingly enough, the cost of this financing included 20%  interest rate on the loan itself plus a $100 fee just to enroll in this program.
I had no choice but to take this particular loan. So I paid the $100 fee, I paid the 20% in interest, and I got my insurance. I took the train back to Princeton. A few days later, of course, I canceled this terrible loan and paid it off. But here is what I learned from this distressing lesson, the moment you make one financial mistake the chances that you will be hit with all kinds of fines, all kinds of difficulties, all kinds of financial obstacles, are much, much higher.
If I was on the verge of financial difficulty there is no question that this particular incident would have pushed me over the edge, making my financial life much more difficult and maybe even impossible. I think that this is, in fact, what we do to people with financial constraints all the time. We impose substantial penalties on the people who violate financial responsibilities, not taking into account their viability and therefore make their lives much, much worse.
How can we get over this issue? I think we have to reconsider the punitive systems all the financial institutions use (insurance, banks, credit cards, etc.), and think more carefully about how we want to share responsibility and payment across people.  After all when someone goes bankrupt, they of course suffer, but so does the whole system around them.  From this perspective, it is easy to see how the punitive systems we are using are not only bad for the individuals but they can be very damaging for the whole society.

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

I wrote this about 8 months ago — but it makes particular sense right now ….

—

If (as is often the case) talking about sex makes people more interested in having it, does that mean that the current talk about a recession could actually be creating one? Well, maybe.

Or so one general finding of behavioral economics would have us believe. With all this chatter about a recession, consumers might, for example, hold off on buying that new dishwasher because of the “bad economy,” or pass up the more expensive restaurant because “we’re in a recession.” Without any discussion about recession, we’re unlikely to change our pattern of behavior. But talking about it can be a force that affects our decisions and alters our consumption habits.What makes me think that we’re such creatures of habit? Consider the experience of eating a Godiva truffle: The chocolate is melting in your mouth, the aroma penetrates your nose, there is a small nut inside. . . . Now think about this familiar experience and try to determine how much it’s worth to you. A quarter? $0.50? $0.75? $1.25? $2.50? While the experience of eating a truffle is very familiar, figuring out what we would be willing to pay for it proves difficult. So what do we do when we make purchasing decisions? (more…)

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? (more…)

How would a behavioral economist look at the sub-prime mortgage crisis in any way that is different from a rational economist?

Here is my perspective on the sub-prime mortgage crisis: When the housing market was hot, all the bankers that gave out loans assumed that their customers didn’t want their house to go into foreclosure, and that they would act accordingly. (more…)

Dear Irrational,

I am a finance professor at one of the top business schools in the U.S., and I am starting to doubt the assumptions of irrationality based on what I see in my students.

Here is the story: Every year when I teach the basic finance class to either the MBAs or the executive MBAs we get to the point where we talk at length about the benefit of diversification, including how to think about risk and return. (more…)

The WSJ recently reviewed a book called “Billion Dollar Lessons”

Here is one of the stories from the book (and the review): (more…)