The psychology of human misjudgment vi

The Psychology of Human

Misjudgment- VI

Bias # 9Incentives & Incentive-

caused bias

“People Respond to incentives.” The rest is commentary

Most of economics can be summarized in four words: “People Respond to incentives.” The rest is commentary- Steven Landsburg

Example 1Freakonomics

Read the book (and its sequel Superfreakonomics), watch the movie.

YouTube - Freakonomics - Official Trailer [HD]

http://www.youtube.com/watch?v=56k1xVAq290

These two guys have done some wonderful work on “incentives.”

Subscribe to their old blog:

Opinion - Freakonomics Blog - NYTimes.com

http://freakonomics.blogs.nytimes.com/

And the New one:

http://www.freakonomics.com

Example 2Demand Curve

Price and Demand are inversely related. Provide two exceptions where to increase

demand, you should increase price.

1. Price associated with quality2. Bribe the customer’s agent to push the product - invoking one the most post powerful psychological tendencies - the superpower of incentives

Boiler Room Scene demonstrating incentive superpower

Are there “functional

equivalents” of boiler room operations?

cocaine, mutual fund units, penny stocks in boiler rooms, medical drugs, time shares, insurance - ANY product with a fat commission behind it. No matter how toxic, it WILL get pushed.

Micro-lending in Andhra Pradesh.

Yes!

“Any time you create large

differences in commissions where the guy gets X% for selling A, which is

some mundane thing, and 10 times

X for selling B, which is something

toxic, you know what’s going to

happen.”

You’ll get lots of B despite its

toxicity.

Moreover it will get rationalized.

Man is not a rational animal, rather man is a rationalizing

animal

I-C Bias is so pervasive it occurs in all professions.

Lawyers make clients litigate more than its necessary.

Doctors prescribing unsuitable medication because its in their own self interest.

Read this blog post I did in 2007:

Fundoo Professor: Incentive-caused Bias in the Medical Profession

http://fundooprofessor.blogspot.com/2007/11/incentive-caused-bias-in-medical.html

Read original article from:

http://www.nytimes.com/2007/11/25/magazine/25memoir-t.html?

Auditors would overlook accounting irregularities and so on…

Client: How much is 1+1?Auditor: How much do you want it to be?

Example 3Credit Rating

Agencies

Read this:

Market Shock: AAA Rating May Be Junk - New York Times

http://select.nytimes.com/2007/07/20/business/20norris.html?_r=1

Read this:

http://www92.homepage.villanova.edu/shawn.howton/Fin%202227/articles/subprimemess.pdf

The process of converting something toxic to something pure…

This is the alchemy of finance.

Read this:

Op-Ed Columnist - All Fall Down - NYTimes.com

http://www.nytimes.com/2008/11/26/opinion/26friedman.html

“Whose bread i eat, his song i sing”

“Fear professional advice especially when it is good for the advisor.”

“Double check, disbelieve, or replace much of what you’re told, to the degree that seems appropriate after objective thought”

Michael Aronstein

I love this quote...

“Of the many advances in the long history of commerce, the advent of sausage stands out as one of the greatest...

“The idea of taking something which, in pure form, would be repellent to potential customers, and by thorough grinding, mixing, reshaping and adulterating, creating an entirely new entity that could be marketed free from the taint of its original ingredients, marked a milestone in the annals of business thought. Sausage making is the prototype for an entire class of merchandising technique that has become particularly common in modern finance. The financial marketer who uses commingling as an approach is responding to the same general conditions that drive the sausage stuffer: an abundance of lower grade ingredients along with hungry and credulous public.” – Michael Aronstein

Be Wary of Financial Innovation…

The guys who do it keep on re-inventing the wheel and hoodwink you into believing that what they are doing “this time, its different.”

Galbraith once wrote: “All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets … All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.”

He was right as you’ll discover when you read “The Great Crash 1929”

Munger advices you to never ask the barber if you need a haircut.

Example 4Tobacco

Scene from “Thank you for smoking”

YouTube - Thank You For Smoking Movie (1/9)

http://www.youtube.com/watch?v=4HC3xwlfcFM

This is a great movie which highlights a man who is a lobbyist for the tobacco industry, does a brilliant job, and faces no cognitive dissonance because he is doing it “for the money.”

However everything changes in the last scene...


YouTube - Thank you for smoking part 4/9

http://www.youtube.com/watch?v=Ft9kOLfd0Vs&feature=related

See from 6:55 onwards


Experiencing Cognitive dissonance

http://www.youtube.com/watch?v=3Quv3ZYf72Q&feature=relatedSee from 5:42 onwardsAndhttp://www.youtube.com/watch?v=h9n-UdMhBNQ&feature=relatedWhen you take up a job, you will have the same problem. All professions have this problem of incentive-caused bias, when you fool yourself into believing that what’s good for you is also good for your client. And so, you will find yourself selling overpriced and unsuitable insurance, addiction, unsuitable products (e.g. tech mutual funds on the top of a tech boom to widows and orphans) just for the money...

I-C Bias is very pervasive. What’s the solution?

According to Munger, the solution is financial independence.


“Any time you create large differences in commissions where the guy gets X% for selling A, which is some mundane thing, and 10 times X for selling B, which is something toxic, you know what’s going to happen.”



Example 5Peddling Leverage in USA - taking 2nd

mortgages for consumption

rather go to bed

supperless than rise in debt -

Ben franklin

This is the story of a founding father of one of the greatest nations - USA, and the subsequent behavior of its citizens and its businesses.

This is the story of debt, and how it got pushed like a drug because there was “money in it”

All you MUST read the following books by Franklin.

Poor Richard’s AlmanakThe Way to Wealth

Frankin gave some very valuable advice to his citizens…

look what they did and look how they were pushed into this by the “extremes of capitalism”

"But what madness must it be to run in debt for these superfluities? We are offered by the terms of this sale, six months' credit; and that, perhaps, has induced some of us to attend it, because we cannot spare the ready money, and hope now to be fine without it. But, ah! think what you do when, I you run I in debt you give to another power over your liberty. If you cannot pay at the time, you will be ashamed to see your creditor; you will be in fear when you speak to him; you will make poor, pitiful, sneaking excuses, and, by degrees, come to lose your veracity, and sink into base, downright lying; for The second vice is lying, the first is running in debt, as Poor Richard says.”

The love of debt, like any addiction, WILL result in breakdown of morality.

its hard for an

empty sack to stand upright -

ben franklin

I love this one…

Example 6Peddling Leverage

in USA - Credit card debt

http://www.youtube.com/watch?v=ysyFqkHXusc

Addiction to debt - promoted by Mastercard.

Take a good idea (credit cards), then take it to the extreme (as capitalism does), and then see what happens. It results in DISASTER every time.

Watch this documentary:

http://topdocumentaryfilms.com/maxed-out/

How are the credit card companies any different than Shakespeare’s Shylock in “The Merchant of Venice?” Also see:

Super size Me

http://freedocumentaries.org/film.php?id=98

And think about the cognitive dissonance faced by managers of McDonalds if they see this film...

Maxed Out | Watch Free Documentary Online


since The borrower is a slave to the

lender and the debtor to the

creditor, disdain the chain,

preserve your freedom; and maintain your

independency. - benjamin franklin

Who says slavery has gone?

Its here - alive and kicking. All those people who will work all their lives for their credit card companies? Who are these people? If they are not slaves then what are they?

silk and satins,

scarlets and

velvets, put out the

kitchen fire- ben franklin



Role of financial independence- Makes you see things as they really are.

Its very tough for someone who is not financially independent to escape from the clutches of incentive-cased bias…

Its difficult to get a man to understand something, when his

salary depends upon his not

understanding it - Upton sinclair

Example 7diet and the Fast Food and Pharma

Industries

Me two years ago

http://en.wikipedia.org/wiki/Super_Size_Me

Fat, Sick, and Nearly Dead

http://www.youtube.com/watch?v=x9SGWcZwk7c

Forks over knives

http://www.youtube.com/watch?v=O7ijukNzlUg

Food Matters

http://www.youtube.com/watch?v=r4DOQ6Xhqss

Promptly resolve cognitive dissonance...

“Whose bread i eat, his song i

sing”

Example 8Investment Banking

Investment banker making a pitch to clients.

Why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, but instead keep in mind the story of the man with an ailing horse. Visiting the vet, he said: "Can you help me? Sometimes my horse walks just fine and sometimes he limps." The vet's reply was pointed: "No problem – when he's walking just fine, sell him." ... At Berkshire, we have all the difficulties in perceiving the future that other acquisition-minded companies do. Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale – a time when the business is likely to be walking "just fine." – WB

“This fishing tackle manufacturer I knew had all these flashy

green and purple lures. I asked, ‘Do fish

take these?

“Charlie?’ he said, ‘I don’t sell these lures to fish.’” — Munger

Game-able systemsleading to unintended

consequences(Peltzman effect)

Take a look at this commercial. It has all the attributes of an effective commercial. See for yourself:

YouTube - Awesome "Buckle Up" PSA Commercial

http://www.youtube.com/watch?v=m6ZKVdKTWww

The PSA commercial on previous slide was persuasive, but was it right?Take a look at this:YouTube - Sam Peltzman on the Peltzman Effect

http://www.youtube.com/watch?v=7IB2xRfRHOA

Peltzman effect - Wikipedia, the free encyclopediahttp://en.wikipedia.org/wiki/Peltzman_effect

The Peltzman effect is a contributing factor in the explanation of Smeed's Law, an empirical observation that traffic fatality rates in many countries are correlated with the number of vehicle registrations per capita, and differing safety standards do not appear to be significant.

Peletzman effect is a mental model which tells you to not ignore the second or third order effects like the designer of the incentive scheme which rewarded students a $1 for catching a rat on campus after all other efforts to get rid of the rats failed. Well, pretty soon, the students were breeding rats…

People not only respond to incentives, sometimes one’s well-intentioned decisions result in perverse outcomes. We call that “perverse incentives.” Read more about this from:

http://en.wikipedia.org/wiki/Perverse_incentive

are there “functional

equivalents” of the peltzman effect?

Example 9

Price Controls

Oh Yeah?

“You can either control the price, or the

supply, but not BOTH!”

See “Will Indian Steel Disappear?”

Black MarketsLicense raj

Ration shops

Jim Rogers

http://www.blonnet.com/2004/08/31/stories/2004083100111100.htm

If you fix price too low, supply will vanish!If you fix the supply (e.g. license raj) and then try to impose price controls also, you will see a black market emerge.

Low price of diesel vs petrol

Smugglers and black marketeers vs. Arbitrageurs

Cocaine Incorporated - The New York Times

http://www.thehindubusinessline.com/opinion/columns/aarati-krishnan/article3935602.ece?homepage=true

Example 10

Credit default swaps

Pitched as an “insurance product”

What happens when CDS are bought by hedge funds with no insurable interest?

i.e. who have nothing to lose from the demise of the corporation, are not “insurance” in the true sense of the word.

Leaking bad news to media

Planting false stories

Pressurizing bankers to recall their loans

etc..

Example 9:Carol loomis on

“The risk that won’t go away”

The risk that won’t go away

Law of conservation of risk

The risk that STILL wont go away

http://money.cnn.com/2008/09/25/magazines/fortune/loomis_swamp.fortune/index.htm

http://money.cnn.com/2009/06/22/news/economy/derivatives_regulation_risks.fortune/index.htm

http://fundooprofessor.blogspot.com/2005/09/carol-loomis-risk-and-law-of.html

Example 11Wall Street Casino

Buffett’s column: How to tame the casino society

Perverse incentives out of low brokerage costs.

How does HE deal

with incentives?

Example 12Scott Fetzer

What’s Causing This???

“In setting compensation, we like to hold out the

promise of large carrots, but make sure their

delivery is tied directly to results in the area

that a manager controls. When capital invested in

an operation is significant, we also both charge managers a high

rate for incremental capital they employ and

credit them at an equally high rate for capital they

release.

“The product of this money's-not-free approach is definitely visible at Scott Fetzer. If Ralph can employ incremental funds at good returns, it pays him to do so: His bonus increases when earnings on additional capital exceed a meaningful hurdle charge. “But our bonus calculation is symmetrical: If incremental investment yields sub-standard returns, the shortfall is costly to Ralph as well as to Berkshire. The consequence of this two- way arrangement is that it pays Ralph - and pays him well - to send to Omaha any cash he can't advantageously use in his business.”

Example 13GEICO

“The bonuses received by dozens of top executives,

starting with Tony, are based upon only two key variables: (1) growth in voluntary auto policies and (2) underwriting profitability on “seasoned”

auto business (meaning policies that have been on the

books for more than one year).”

Example 14H.H. Brown

“A distinguishing characteristic of H. H.

Brown is one of the most unusual compensation

systems I’ve encountered - but one that warms my heart: A number of key managers are paid an

annual salary of $7,800, to which is added a

designated percentage of the profits of the company after these are reduced by

a charge for capital employed. These managers therefore truly stand in

the shoes of owners.”

“In contrast, most managers talk the talk but don't walk the walk, choosing instead to employ compensation systems that are long on carrots but short on sticks (and that almost invariably treat equity capital as if it were cost-free). The arrangement at Brown, in any case, has served both the company and its managers exceptionally well, which should be no surprise: Managers eager to bet heavily on their abilities usually have plenty of ability to bet on.”

Example 15Ending the deficit

“If you were to persuade, appeal to

interest not reason” - Ben

franklin

Bias # 10Pavlovian

Association

This is the famous dog of pavlov who learnt to salivate at the sound of a bell.

The human equivalent of the pavlovian dog is there in all of us.

Invert, Always Invert

:-)

pattern seeking is pavlovian misassociation

Looking for trends when there aren’t anyAssociating Trend with DestinyWill this stock keep going up? vs. Has this stock been going up?Mind looks for patterns in things that are random.

Michael Shermer: Pattern Seeking Video

http://www.ted.com/talks/michael_shermer_on_believing_strange_things.html

Pavlovian Association

Restaurants stopped serving tandoori items and sale of

tandoors plunged...

High price associated with high quality

e.g. Nakshatra diamonds

made by De Beers

Advertisers demonstrate the power of positive associations by constantly

connecting their products with the things we like.

Advertisers demonstrate the power of positive associations by constantly connecting their products with the things we like.Girl Models next to Car ModelsLending positive traits of beauty and desirabilityYou won’t see Coke advertised alongside some account of the death of a child. Instead, Coke ads picture life as happier than reality.

“Throwing the baby out with the bathwater”“If Satyam Computers is a fraud, then all IT companies are frauds, so I am going to dump them all.” - Mr. MarketUnder what circumstances, Mr. Market would be wrong?

Painting Everything with the

same brush

“Painting everything with the same brush”A drop in price of steel is bad news for ALL steel companies, so I am going to dump them all.” - Mr. Market.Under what circumstances, Mr. Market would be wrong?

“Our inferential machinery, that we use in daily life, is not made for a complicated environment in which a statement changes markedly when its wording is slightly modified. Consider that in a primitive environment there is no consequential difference between “most killers are wild animals” and “most wild animals are killers.” The error here is almost inconsequential.

“Our statistical intuitions have not evolved for a habitat in which these subtleties can make a big difference.”

between 1983 and 1993, when butter production was up 1%, the S&P 500 was up 2%

the next year. Conversely, if butter production was down 10%, S&P 500 DECLINED

BY 20%.

Co-relation and causation

Insensitivity to Base Rates (Probability

unconditioned on featured

evidence)

Base rate is the probability unconditioned on featural evidence, frequently also known as prior probabilities. For example, if it were the case that 1% of the public are "medical professionals" and 99% of the public are not "medical professionals," then the base rates in this case are 1% and 99%, respectively.

“In all free-enterprise attitudes there is a strong tendency to believe that the more money, either as income or assets, of which an individual is possessed, the deeper and more compelling his economic and social perception, the more astute and penetrating his mental processes. In a world where for many the acquisition of money is difficult... the possession of it in large amount seems a miracle. Accordingly, possession must be associated with some special genius.”- Galbraith

Mis-associating good outcomes with skill (stock market swindle, massively outperforming fund etc.)Mis-associating bad outcomes with bad processUnder-appreciation of role of luck

Role of Luck

Summer of 2000

Simone Tata, Chairperson of

Trent & Stepmother of

Ratan Tata, Chairman of the

Tata Group

http://en.wikipedia.org/wiki/Simone_Tata

2002

1.In 2002, a class-project report on a company called Trent landed on my table and when I opened it my eyes popped out again!2.Lakme, a highly valued cosmetics company had, some time back, sold off its brands to Unilever. Lakme was controlled by the Tata’s one of India’s largest business groups.3.The lady who was running the company, in her own wisdom decided to not distribute the money to the company’s stockholders. Instead, she announced a foray into retail business of running departmental stores - TRENT - WESTSIDE4.That market hated that decision - NEXT SLIDE

Trent’s Stock Price Chart

1.Over the next few years, as retail boom took off, so did the stock - what we bought for Rs 68 was now quoting at Rs 800.2.When someone asks me when will I buy a retail stock, my favorite answer is “when its free!”3.Value investing does have a tendency to spoil you!4.The key lesson here is that while we may try to be catalysts in unlocking value, to succeed here is not a precondition - there may be OTHER catalysts in place will will give you a very nice exit.

“Chance favors the

prepared mind.” - Louis

Pasteur

http://en.wikipedia.org/wiki/Serendipity

You find something when you’re not looking for it.do not ignore the importance of accidental discoveries - events, meetings, chance happenings - keep an open mind to all possibilities.

I love what Taleb has to say about

inventions, how almost all of the

discoveries that have had tremendous impact on our culture were

accidents in the sense that they were

discovered while searching for

something else. Arlene Goldbard, Blogger

“Because of hindsight bias, he says, histories of economic life and scientific discoveries are written with straightforward story lines: someone set out to do something and succeeded, it’s all about intention and design. But in truth, “most of what people were looking for, they did not find. Most of what they found they were not looking for. Penicillin was just some mold inhibiting the growth of another lab culture; lasers at first had no application but were thought to be useful as a form of radar; the Internet was conceived as a military network; and despite massive National Cancer Institute-funded cancer research, the most potent treatment—chemotherapy—was discovered as a side-effect of mustard gas in warfare (people who were exposed to it had very low white blood cell counts). Look at today’s biggest medical moneymakers: Viagra was devised to treat heart disease and high blood pressure.”

... until they are too heavy to be

broken - Warren Buffett

Chains of habit are too light to

be felt ...

Don’t take the same route to office, don’t listen to same type of music, don’t read papers from front page, don’t order from a menu from starters to desserts, expose yourself to different cultures - you don’t know what you idea might stumble upon…and when u get that flash of inspiration - your idea - JOT it down - some of the best business plans were made on napkins

Allow one thing to lead to another (serendipity)

Be connected- Linkedin, Facebook, etc…

“Go where events flow

fastest. Surround

yourself with a churning mass of people and

things happening.”

“But why is she in the right places at the right times? Because she has

made the effort to be in many places

at many times. Fate has given her a lucky break, but she has earned it. She has positioned

herself for it.”

Drop what you’re doing when you get an interesting opportunity, call etc - DONT IGNORE IT!

“It is a fundamental assumption of the Work Ethic that people ought to have goals and should

struggle toward them in a straight line. We are counseled to fix our eyes on our goals,

looking neither to the right nor to the left, refusing to be

distracted.

Max Gunther

This is supposed to be the sure route to success. But here is a puzzling fact. It turns out that lucky men and women, on the whole are not straight-line strugglers. They not only permit themselves to be distracted, they invite distraction. Their lives are not straight lines but zigzags.”

"I have encountered many branches in the maze of life's path, where I have followed now the left

fork, now the right. . . .In describing my life as

maze-like, I do not mean that I have a large

number of deliberate, wrenching decisions to go off in one direction or

another.

Herb Simon

On the contrary, I have made very few. Obvious responses to opportunities and circumstances, rather than studied decisions, have put me on the particular roads I have followed."

“The lucky... are aware that life is always going to be a turbulent sea of

opportunities drifting randomly

past in all directions.”

“If you put blinders on yourself so that you can see only straight ahead, you will miss nearly everything. This is what the unlucky typically do. They stick to preplanned life routes even when they are going nowhere or are actually plodding downhill to disaster.”- Max Gunther

Search strategy - I do not ignore serendipity

The Rabbit Runs Faster than the Fox because the Fox is only running for his dinner while the

rabbit is running for his life.

Ideas can come from screens, company management interaction, reading “news” - ignore macroeconomic, focus on company specific - management interviews or make up ur own news by looking at fundamental, slow but long-term changes happening to companies.

ideas come from reading books from multiple disciplines, even Aesop fables.

Rise in the price of a raw material leads to the idea of looking at the company which supplies the raw material

Bias # 11

REASON RESPECTING TENDENCY

“Excuse me. I have five pages. May I use the Xerox

machine?”Compliance Rate:

64%

Reason Respecting TendencyThe word “because” is one of the most powerful words in English.

“Excuse me, I have five pages. May I use the

Xerox machine because I am in a rush?”

Compliance Rate: 94%

“Excuse me. I have five pages. May I use the

Xerox machine because I have to make some

copies?”Compliance Rate:93%

Implication for us:

Because people want reasons which explain why something happened, there are people who materialize to offer reasons even when there isn’t any.

Bias # 12

PAIN REDUCING PSYCHOLOGICAL

DENIAL

I call this the “Dam Fools” Model - Pain Reducing Psychological Denial. This from Jared Diamond:

“The last reason that I shall mention for irrational failure to try to solve a perceived problem is psychological denial. This is a technical term with a precisely defined meaning in individual psychology, and it has been taken over into the pop culture. If something that you perceive arouses an unbearably painful emotion, you may subconsciously suppress or deny your perception in order to avoid the unbearable pain, even though the practical results of ignoring your perception may prove ultimately disastrous. The emotions most often responsible are terror, anxiety, and sadness. Typical examples include refusing to think about the likelihood that your husband, wife, child, or best friend may be dying, because the thought is so painfully sad, or else blocking out a terrifying experience. For example, consider a narrow deep river valley below a high dam, such that if the dam burst, the resulting flood of water would drown people for a long distance downstream. When attitude pollsters ask people downstream of the dam how concerned they are about the dam's bursting, it's not surprising that fear of a dam burst is lowest far downstream, and increases among residents increasingly close to the dam. Surprisingly, though, when one gets within a few miles of the dam, where fear of the dam's breaking is highest, as you then get closer to the dam the concern falls off to zero! That is, the people living immediately under the dam who are certain to be drowned in a dam burst profess unconcern. That is because of psychological denial: the only way of preserving one's sanity while living immediately under the high dam is to deny the finite possibility that it could burst.”

There is much denial in the world of business. Witness what’s happening in the banking sector right now.

A Cocoon of Unreality

Refusal to look at stock market pages when

facing massive losses vs. doing frequent

marking to market of portfolios during bull

runs

“I think its in the nature of things

for some businesses to die.

Its also in the nature of things

that in some cases, you shouldn’t

fight it...

“There’s no logical answer in some cases except to wring the money out and go elsewhere. And that’s very tough for managements to do. In fact, they almost never face up to that. It’s very rare.” — Munger.

Perverse incentives:

Restructured assets - DenialEvergreeningThrowing good money after bad.

“I don't want you to think we have any way of learning or behaving so you won't make mistakes. I'm just saying that you can learn to make fewer mistakes than other people - and how to fix mistakes

faster when you do make them...

“But there's no way you can live an adequate life without making many

mistakes.

In fact, one trick in life is to get so you can handle mistakes. Failure to handle psychological denial is a common way

for people to go broke...

“You've made an enormous commitment to something. The more the effort and money

you’ve poured in, the more the whole consistency principle makes you think: "Now it has to work, If I put in just a little more,

then it'll work.“ [Contrast- boiling frog]

And deprival super-reaction syndrome also comes in: You're going to lose the whole thing if you don't

put in a little more. People go broke that way - because they can't stop and rethink and say: "I can afford to write this one off and live to fight again. I don’t have to pursue this thing as an

obsession - in a way that will break me...

Part of what you must learn is to handle mistakes and new facts that change the odds. Life, in part, is like a poker game,

wherein you have to learn to quit sometime when holding a much-loved hand.”

Thank You

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