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 …

another paper on cheating is out: http://tinyurl.com/b7tkpw

An interesting story out of the BBC: one priest, Father Tim Jones, recently gave an incredibly provocative sermon where he offered controversial advice–to shoplift. His argument is basically that those who are less fortunate may often turn to illegal means: they can rob, they can become prostitutes, etc… Jones is arguing that of these “evils,” shoplifting, especially from large corporations, has the least impact on society, and thus, somehow, is the least immoral. Of course from a psychological standpoint this is our intuition. It is easy to do harm to large corporations because we think that we are spreading our damage out evenly among more individuals, and, moreover, those individuals are faceless people wearing suits. However, giving this more thought, we can also sense that if we were to allow this to happen as a society (or be more forgiving of poor people who steal from big corporations to get by), we could very quickly slip into a system of mutual distrust. Before you know it, we will all be having to have our bags checked at entrances and exits, with costs going up for everyone. On the whole, this might leave fewer people with jobs, and the cycle could continue to spiral out of control. As we know, many of the biggest financial blunders of the recent years had to do with tiny misjudgments that added up to larger and more catastrophic costs, with the resulting mutual distrust freezing credit and badly hurting the economy. One thing we must beware of is the allure of thinking that our tiny, seemingly inconsequential decisions won’t matter much in the long run. As history and research have shown us, it’s the little decisions that we gloss over that end up hurting us most in the end.

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?

Every time I think that cheating in the public sector cannot possibly get worse I get amazed.

Here is a report from the New York Times, that I find just unbelievable.
The basic story is that the Interior Department agency responsible for collecting oil and gas royalties has been caught up in a wide-ranging ethics scandal — including allegations of financial self-dealing, accepting gifts from energy companies, cocaine use, and sexual misconduct.

I am not going to summarize it but here are my 2 reflections:

1) Will Congress actually do something with these reports and take some action to correct the situation (I suspect not)?
2) Was it relatively easy for the Interior Department agency that collects oil and gas royalties to be dishonest given the general lack of morality in the oil and gas industry? In other words, does the lack of ethical behavior in the corporate world also transfer to the government branches that are dealing with these sectors? I suspect that the answer is “yes” and this is very troubling — since the government agencies that need to be more honest are the ones dealing with more corrupt industries.

Sadly yours

Dan

In the aftermath of Spygate, reading the deluge of blog postings—especially those by bloggers outside of New England—may have led one to the conclusion that Bill Belichik was a calculated cheat who took planned risks and in the process tarnished the sacred reputation of a national treasure. This is, of course, not the first time that someone in a position of power has engaged in regrettable behavior, and it is also not the first time that the public and the media has rushed to label such behavior as the act of an unethical individual—a “bad apple.” We suggest that this rush to label such behaviors as the actions of one unethical individual often obscures rather than informs our understanding of such behavior, and more importantly it provides no lessons to help us understand and think about how to prevent such behaviors in the future. (more…)

One of the positive side effects of writing Predictably Irrational is that sometimes people try their own versions of these experiments. Here is one email describing an experiment on cheating and toilet paper – demonstrating the wide range of application of behavioral economics….

Dear Professor Ariely,

I am a fan of your research. I particularly liked your experiments on cheating (i.e. the non-existent “MIT honor code” and 10 Commandments example) and thought that I could apply your hypothesis in an experiment of my own.

I live in a house near the U.C. Berkeley campus (where I just graduated last semester). The house is shared with many housemates, and most of us do not know each other before moving in. Moreover, this summer a bunch of foreign exchange students are also living in the house. This living arrangement has led to a number of problems– namely the stealing of toilet paper. (more…)

I recently came across this article in the New York Times that describes a new movement among doctors and hospitals to admit their mistakes rather than continue with the more traditional approach of denying and defending them. As a result, the article suggests, these hospitals are seeing a decline in lawsuits and legal costs. I suspect that this has something to do with the fact that in these hospitals the patients are being treated with an approach that is usually reserved for meaningful, social relationships.
(more…)

The New York Times today had a story about Jennifer Buettner, who is trying to make a placebo pill for kids, but maybe for all of us.

Is this a good idea?

We know that in many cases placebos do work, and we also know that they have very few side effects — a point for placebo pills! (more…)

Imagine that you worked for me, and as your year-end bonus, I offered you a choice between $1,000 in cash or an all expense paid weekend in the Bahamas, also worth $1,000.

Which option would you chose? (more…)