Tag: Incentives

Can one person successfully play different roles that require different, and often competing, perspectives?

No, according to research by Max Bazerman, author of the best book on decision making I’ve ever read: Judgment in Managerial Decision Making.

Contrary to F. Scott Fitzgerald’s famous quote, “the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function,” evidence suggests that even the most intelligent find it difficult to sustain opposing beliefs without the two influencing each other.

Why?

One reason is a bias from incentives. Another is bounded awareness. The auditor who desperately wants to retain a client’s business may have trouble adopting the perspective of a dispassionate referee when it comes time to prepare a formal evaluation of the client’s accounting practices.

* * * * *

In many situations, professionals are called upon to play dual roles that require different perspectives. For example, attorneys embroiled in pretrial negotiations may exaggerate their chances of winning in court to extract concessions from the other side. But when it comes time to advise the client on whether to accept a settlement offer, the client needs objective advice.

Professors, likewise, have to evaluate the performance of graduate students and provide them with both encouragement and criticism. But public criticism is less helpful when faculty serve as their students’ advocates in the job market. And, although auditors have a legal responsibility to judge the accuracy of their clients’ financial accounting, the way to win a client’s business is not by stressing one’s legal obligation to independence, but by emphasizing the helpfulness and accommodation one can provide.

Are these dual roles psychologically feasible?; that is, can one person successfully play different roles that require different, and often competing, perspectives? No.

Abstract

This paper explores the psychology of conflict of interest by investigating how conflicting interests affect both public statements and private judgments. The results suggest that judgments are easily influenced by affiliation with interested partisans, and that this influence extends to judgments made with clear incentives for objectivity. The consistency we observe between public and private judgments indicates that participants believed their biased assessments. Our results suggest that the psychology of conflict of interest is at odds with the way economists and policy makers routinely think about the problem. We conclude by exploring implications of this finding for professional conduct and public policy.

Full Paper (PDF)

Read what you’ve been missing. Subscribe to Farnam Street via Email, RSS, or Twitter.

Shop at Amazon.com and support Farnam Street

Seth Klarman: The Forgotten Lessons of 2008

Seth Klarman: The Forgotten Lessons of 2008

In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.”

* * *

The Forgotten Lessons of 2008

One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

  1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
  2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
  3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
  4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
  5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
  6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
  7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
  8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
  9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
  10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
  11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
  12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
  13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
  14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
  15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
  16. Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
  17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
  18. When a government official says a problem has been “contained,” pay no attention.
  19. The government – the ultimate short- term-oriented player – cannot with- stand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
  20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

  1. There are no long-term lessons – ever.
  2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.
  3. There is no amount of bad news that the markets cannot see past.
  4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.
  5. Excess capacity in people, machines, or property will be quickly absorbed.
  6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.
  7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.
  8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.
  9. The government can indefinitely control both short-term and long-term interest rates.
  10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)

***

Still curious? Check out Basically, It’s Over: A Parable About How One Nation Came To Financial Ruin by Charlie Munger.

Machiavelli’s Mistake: Why Good Laws Are No Substitute For Good Citizens

A summary of Samuel Bowles’ lecture series entitled “Machiavelli’s Mistake” at the Santa Fe Institute.

1. Moral Sentiments and Material Interests

The classical thinkers from Aristotle to Aquinas, Rousseau, and Burke recognized the cultivation of civic virtue not only as the test of good governance, but also as its essential foundation. Machiavelli and Hobbes broke with this Aristotelian tradition.

Readers of Machiavelli’s Discourses learned that “all men are wicked … hunger makes them industrious, laws make them good.” Adam Smith’s invisible hand provided a decentralized model for how this constitutional alchemy might be accomplished. Good institutions thus came to displace good citizens as the sine qua non of good government. Prices would do the work of morals.

This classical economists approach – now the canonical model of policy-making in economics– now does not ignore moral behavior, but instead assumes it to be unaffected by incentive-based policies designed to harness self-interest. Along with civic virtue, explicit incentives and constraints could thus contribute additively to good government. The classical writers did not worry that laws designed to induce “wicked” citizens to act as if they were good might induce even the good to act as if they were wicked.

They should have worried. Experimental and other evidence show that while most individuals are far from wicked, treating people as if they were often crowds out the common generous, ethical, and reciprocal behaviors upon which the functioning of modern liberal democratic societies depend.

2. Is liberalism a parasite on tradition?

The parasitic liberalism thesis holds that markets and other institutions endorsed by liberals depend on family-based, religious and other traditional social norms that are endangered by these very institutions. Liberal society thus fails Rawls’ test of “stability:” it does not “generate its own supportive moral attitudes.” Experimental evidence presented in Lecture I, provides support for the idea. I represent the thesis in a model of the dynamics of institutional and cultural change, indicating the conditions under which the cultural dynamic of liberal society leads to economic dysfunction, instability and eventually collapse. I then provide surprising cross-cultural evidence that is inconsistent with the implications of the model.

Liberal societies are distinctive in their civic cultures, exhibiting levels of generosity, fairmindedness, and civic involvement that distinguish them from non-liberal societies. The parasitic liberalism thesis fails not because it misunderstands the cultural consequences of markets, but rather because it overrates the benign contribution of tradition to the moral underpinnings of liberal institutions, and underrates the contribution of the liberal state and other non-market aspects of the liberal social order to the flourishing of these civic virtues.

3. Machiavelli ‘s Mistake: Do good fences make good (enough) neighbours?

Two empirical puzzles show that some incentives work almost exactly as conventional economic theory predicts while others backfire. Under what conditions, then, can prices do the work of morals. Unraveling these puzzles and answering this question requires an understanding of the causal mechanisms by which material incentives crowd out moral motives. Experimental and other evidence suggests that explicit incentives and social motivations may be less than additive due to individual desires for autonomy, self esteem and fairness, which may be compromised by incentives. The material incentives favored by economists can also crowd out institutions that provide at least second best governance of social dilemmas.

How should a sophisticated hypothetical social engineer – that is, one who is aware of the motivational and institutional crowding out problem – design policies and institutions? Three results are demonstrated. First the optimal use of incentives may be either greater or less in the presence of motivational crowding out compared to a case where it is absent. Second, cultural market failures are pervasive, and result in overuse of markets even under ideal conditions for (Coasean) bargaining in the design of property rights and other institutions. Finally, a new second best theorem is proposed: the better definition of property rights and other policies considered by economists to improve incentives may degrade economic performance when they crowd out ethical motivations and alternative governance institutions.

How credit cards bribe the purchasing agent

“They competed on the basis of raising prices. What other industry do you know that gets away with that?”

Charlie Munger talks about how you can bribe the purchaing agent.

I have one more anecdote: I have fun with this when I speak in front of students and professors. I say, “You all understand supply and demand curves. If you raise price, you sell less, but make more margin. So, give me four instances where the correct answer is to raise the price [meaning volume will go up].” I’ve done this about four times, and maybe one person in 50 can give me one answer that’s correct.

A recent New York Times article illuminates how Visa raises prices and bribes the purchasing agent (in this case, bank) with some of the proceeds.

Competition, of course, usually forces prices lower. But for payment networks like Visa and MasterCard, competition in the card business is more about winning over banks that actually issue the cards than consumers who use them. Visa and MasterCard set the fees that merchants must pay the cardholder’s bank. And higher fees mean higher profits for banks, even if it means that merchants shift the cost to consumers.

Seizing on this odd twist, Visa enticed banks to embrace signature debit — the higher-priced method of handling debit cards — and turned over the fees to banks as an incentive to issue more Visa cards. At least initially, MasterCard and other rivals promoted PIN debit instead.

As debit cards became the preferred plastic in American wallets, Visa has turned its attention to PIN debit too and increased its market share even more. And it has succeeded — not by lowering the fees that merchants pay, but often by pushing them up, making its bank customers happier.

In an effort to catch up, MasterCard and other rivals eventually raised fees on debit cards too, sometimes higher than Visa, to try to woo bank customers back.

“What we witnessed was truly a perverse form of competition,” said Ronald Congemi, the former chief executive of Star Systems, one of the regional PIN-based networks that has struggled to compete with Visa. “They competed on the basis of raising prices. What other industry do you know that gets away with that?”

Social Dilemmas: When to Defect and When to Cooperate

Social dilemmas arise when an individual receives a higher payoff for defecting than cooperating when everyone else cooperates. When everyone defects they are worse off. That is, each member has a clear and unambiguous incentive to make a choice, which if made by all members provides a worse outcome.

A great example of a social dilemma is to imagine yourself out with a group of your friends for dinner. Before the meal, you all agree to share the cost equally. Looking at the menu you see a lot of items that appeal to you but are outside of your budget.

Pondering on this, you realize that you’re only on the hook for 1/(number of friends at the dinner) of the bill. Now you can enjoy yourself without having to pay the full cost.

But what if everyone at the table realized the same thing? My guess is you’d all be stunned by the bill, even the tragedy of the commons.

This is a very simple example but you can map this to the business word by thinking about healthcare and insurance.

If that sounds a lot like game theory, you’re on the right track.

I came across an excellent paper[1] by Robyn Dawes and David Messick, which takes a closer look at social dilemmas.

A Psychological Analysis of Social Dilemmas

In the case of the public good, one strategy that has been employed is to create a moral sense of duty to support it—for instance, the public television station that one watches. The attempt is to reframe the decision as doing one’s duty rather than making a difference—again, in the wellbeing of the station watched. The injection of a moral element changes the calculation from “Will I make a difference” to “I must pay for the benefit I get.”

The final illustration, the shared meal and its more serious counterparts, requires yet another approach. Here there is no hierarchy, as in the organizational example, that can be relied upon to solve the problem. With the shared meal, all the diners need to be aware of the temptation that they have and there need to be mutually agreed-upon limits to constrain the diners. Alternatively, the rule needs to be changed so that everyone pays for what they ordered. The latter arrangement creates responsibility in that all know that they will pay for what they order. Such voluntary arrangements may be difficult to arrange in some cases. With the medical insurance, the insurance company may recognize the risk and insist on a principle of co-payments for medical services. This is a step in the direction of paying for one’s own meal, but it allows part of the “meal’ ‘ to be shared and part of it to be paid for by the one who ordered it.

The fishing version is more difficult. To make those harvesting the fish pay for some of the costs of the catch would require some sort of taxation to deter the unbridled exploitation of the fishery. Taxation, however, leads to tax avoidance or evasion. But those who harvest the fish would have no incentive to report their catches accurately or at all, especially if they were particularly successful, which simultaneously means particularly successfully—compared to others at least—in contributing to the problem of a subsequently reduced yield. Voluntary self-restraint would be punished as those with less of that personal quality would thrive while those with more would suffer. Conscience, as Hardin (1968) noted, would be self-eliminating. …

Relatively minor changes in the social environment can induce major changes in decision making because these minor changes can change the perceived appropriateness of a situation. One variable that has been shown to make such a difference is whether the decision maker sees herself as an individual or as a part of a group.

Footnotes
  • 1

    Dawes RM, Messick M (2000) Social Dilemmas. Int J Psychol 35(2):111–116

The Psychology of Pirates: How to Choose a Ransom

Reading The Invisible Hook really got me hooked on learning more about pirates.

How do pirates decide what ransom to ask for?

The answer, from an interview with an actual pirate, might surprise you. Despite what many think, they are very smart and intuitively grasp governance, incentives, and other aspects of human nature. This interview touches on incentives, reinforcement, moral hazard, and anchoring.

How do you pirates decide on what ransom to ask for?

Once you have a ship, it’s a win-win situation. We attack many ships everyday, but only a few are ever profitable. No one will come to the rescue of a third-world ship with an Indian or African crew, so we release them immediately. But if the ship is from Western country or with valuable cargo like oil, weapons or then its like winning a lottery jackpot. We begin asking a high price and then go down until we agree on a price.

How do you know a ship in far away coast in the first place and its flagship?

Often we know about a ship’s cargo, owners and port of origin before we even board it. That way we can price our demands based on its load. For those with very valuable cargo on board then we contact the media and publicize the capture and put pressure on the companies to negotiate for its release.

From what I’ve seen, initial demands tend to be about 10 times the previous publicized ransom, is this a rule of thumb?

We know that we won’t get our initial demands, but we use it as a starting point and negotiate downwards to our eventual target.  But as a rule, yes, that’s about right.

Does the length of a hijacking change the ransom that pirates are willing to accept?

Yes. Armed men are expensive as are the laborers, accountants, cooks and khat suppliers on land. During long negotiations our men get tired and we need to rotate them out three times a week. Add to that the risk from navies attacking us and we can be convinced to lower our demands.

 

What are the key factors to making a successful attack on a ship?

The key to our success is that we are willing to die, and the crews are not. Beyond that, in my case deploy a boat with six men to get close to the ship and leave another in reserve near the coast just in case we need backup. We use sophisticated equipment that allows us to spot our targets from a distance. We always have to be close to the main sea lane and keep in touch with each other using talkie phones.

 

How much does it cost to outfit a pirate mission?

A single mission with 12 armed men and boats costs a little over $30,000. But a successful investor has to dispatch at least three or four missions to get lucky once.

How are the pirates organized? (Are there pirate leaders, financiers, and specialists?)

The financiers are the most important since they organize and plan the big shot operations and are able to pay running cost[s]. Financiers always need to forge deals with traders, land cruiser owners, translators, business people to keep the supplies flowing during operations and manage the logistics.  There is a long supply chain involved in every hijacking.

 

Are there internal conflicts within the pirate gangs?

No. In piracy, everyones’ life depends on everyone else’s. There is some professional competition between groups, but we cooperate with information and logistics when it’s required. We won’t fight amongst ourselves as long as the money is paid as promised.  We have never had any conflicts within my group.

 

***

Still curious? The Invisible Hook looks at legendary pirate captains like Blackbeard, Black Bart Roberts, and Calico Jack Rackam, and shows how pirates’ search for plunder led them to pioneer remarkable and forward-thinking practices.