Beyond the Dismal Science

The Passionate Science

Back in the nineteenth century Thomas Carlyle described economics as “the dismal science”, a term that’s been wheeled out ever since whenever some hackneyed journalist or febrile blogger feels the need to criticise something to do with money. It’s a snappy little phrase, and is all too often justified.

Well, now a couple of behavioral economists have written a book that attempts to refute that label. In the words of John List and Uri Gneezy in The Why Axis: Hidden Motives and the Undiscovered Economics of Everyday Life economics is a passionate science – one that is:

“Fully engaged with the entire spectrum of the human emotions … and with the capacity to produce results that can change society for the better”.

So if you want to know how to price wine correctly, or to improve the performance of students or get people to donate more money to charity or level the playing field for women at work then this is the place to start. And if you want a tool kit to improve your performance at, say, investing, then you’re in the right place.

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CEOs: The More You Pay Them, The Worse They Perform

The Peter Principle

"Every new member in a hierarchical organization climbs the hierarchy until he/she reaches his/her level of maximum incompetence"

The Peter Principle states that everyone gets promoted to a level at which they're incompetent. More generally Lawrence Peter observed that anything that works gets used to do other things until it fails. This is true even of ideas, and sometimes even failure doesn't stop them being promulgated. Consider, for instance, economics as the primary example of an idea stretched beyond its elastic limit.

But at the top of the corporate tree are those executives who've somehow avoided becoming victims of the Peter Principle. Of course, simply becoming a CEO doesn't disprove the idea, it just makes it more likely that we'll have lots of incompetent business leaders who've become really good at blaming other people. And a survey of CEOs suggests that this is exactly true: they're overrated, they're overpaid and they don't deliver for anyone apart from themselves. Why am I not surprised?

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So, What IS the Point of Financial Advisers?

Conflicted

Consumers of environmentally friendly products are more likely to steal; and advisers who disclose their conflicts of interest are more likely to do the same – although they’ll call it something different, of course. Performing a morally good action will often give us the spurious moral justification for doing something bad.

Disclosure is the lawmaker’s go-to action when they need to be seen to do something, because it costs little and is easy to mandate. Unfortunately it comes with a slight problem: it doesn't work. Conflicts of interest need to be avoided, not managed.

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Curiouser and Curiouser: Incentives Through the Looking Glass

Demotivated by Design

The world is full of schemes aiming to incentivize us; we’re spurred on to achieve new targets and scale new heights by the carrot of lucre-based incentivization schemes designed to appeal to our selfish natures.  Which is not surprising because we live in a society characterised by a belief that we’re all out for what we can get, wheeling and dealing in our own self-interest, forever trying to get the maximum reward for the minimum effort.

Which is like determining that 5 is the square root of 17.  Anyone who truly believes that money is the main motivation for most of our behavior is someone whose belief system needs to be carefully inspected with one of those devices used for stirring septic tanks.  Worse still, financial incentive schemes may actually miss the point by undermining our most cherishable quality: curiosity makes the man, even if it flattens the feline.

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Is Your CEO A Psychopath?

“She was interviewing a psychopath.  She showed him a picture of a frightened face and asked him to identify the emotions.  He said he didn’t know what the emotion was but it was the face people pulled just before he killed them.”

(The Psychopath Test, Jon Ronson)

A Boardroom Blitz

Psychopaths lack empathy, are pathological liars, have an enormous sense of self-worth, are impulsive, irresponsible and won’t accept responsibility for their own actions.  They make up 1% of the total population, 25% of the criminal population and, by some accounts, 4% of corporate boardrooms.

Of course, someone who believes that the only role of business is to maximise profits, regardless of the human cost, is only following the mantra of standard economic theory.  On the other hand, an academic discipline that provides covert justification for a behavior pattern that would get you locked up outside corporate HQs may just have reached the end of its natural lifespan.

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When Incentives Go Bad

Strings Attached: Untangling the Ethics of Incentives by Ruth W. Grant

Way back in ’76, when heels were high, flares were wide and hair was long (for the men, at least) a couple of dudes called Michael Jensen and William Meckling proposed a solution to a problem that had vexed even the founders of economics. They attempted to resolve a puzzle that started with Adam Smith and which has ended in the crash to end all crashes; and as ever we’re looking at a set of consequences which was unforeseeable in advance but seems inevitable in retrospect.

The problem was how do you align the interests of the owners of corporations – the shareholders – with those of the managers of the companies? The solution was ingenious, but the chain of events it set off has exposed the nature of the concept of incentives. Because, it turns out, incentives are not neutral economic things, but strike at the very heart of what it means to be human.

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A Lollapalooza Effect – Capitalism & The Death of Wang Yue

Morality and Cuture

Wang Yue, a two-year old Chinese girl, has died after she was run down in the street, then run over again as the driver made off, then ignored by eighteen passers-by and a collection of market traders while she lay injured, before being hit again by another driver who also drove away before, finally, someone pulled her to safety. These events, caught on video by a security camera, have started a furious debate in China over whether the pursuit of profit has destroyed the country’s morality.

More likely, though, is that we’re seeing what happens when multiple behavioural effects combine in the same direction to create a lollapalooza cascade of otherwise inexplicable behavior. For while we may have basic moral principles these can be set aside if our culture encourages us so to do and, if that culture actually provides incentives for us to do so, what you get is children left to die in the street while people walk by.

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On Incentives, Agency and Aqueducts

Risk Management, Roman Style

There’s an aqueduct in Segovia, in Spain, that’s stood the test of time. A lot of water has flowed over that bridge … two thousand years worth, more or less, since it was built by the Roman Empire. Back then risk management consisted of getting the chief engineer to stand underneath the structure when they removed the supports: now that’s a proper incentive.

Incentives stand at the heart of a lot of human behaviour in corporations but financial theorists have had a great deal of difficulty in understanding that an incentive is not necessarily the same as a financial reward. Although the ideas of psychologists and sociologists are slowly seeping through there’s still a long way to go before there’s a proper appreciation of what motivates people. In the meantime we’re stuck with Agency Theory, the sheer power of grim self-interest: it’s like real life but not as we know it.

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Greed’s Not Good For Shareholders

Don't Aim to Maximise Shareholder Value

When we look at the genuinely successful business people of our time, that happy band of folks who’ve created true shareholder value, enriching themselves and their followers to an astonishing degree, we find an extraordinary thing. The vast majority of these people are not particularly interested in money and their companies are generally not dedicated to some New Age declaration of shareholder value maximisation.

Greed is not a quality that seems to drive the world’s greatest creators of shareholder value and creating shareholder value is not the aim of the companies that are best at it. In fact we can pretty much guarantee the alternative: wherever you find over-rewarded executives presiding over companies whose main aim is to increase their market capitalisation we should pick up our skirts and get the hell out of it. Corporate greed is bad for ordinary shareholders.

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CEO Pay – Because They’re Worth It?

Poor Chief Executives

In the United States CEO pay dropped by an average of 2% in 2009. Still, ordinary workers needn’t shed too many tears as the average total compensation for an S&P500 CEO hovered around the $11 million mark. Perhaps more significant is the gap between the average CEO’s and the average worker’s pay. From CEO’s earning 42 times more than employees in 1980 this soared to a factor of 525 in 2000 before declining to a still eye-watering 319 times in 2009. Here in the UK we find a similar discrepancy between the boardroom and the shop floor.

This doesn’t automatically mean that CEO’s are overpaid, although there’s no evidence either way that they’re providing 319 times more value than their underlings. Indeed, it’s hard to see how you could ever disentangle the various causes and effects to determine this. What we can do, however, is look under the covers at why CEO rewards may be so high: and, as you might expect, it looks like this is less to do with performance and more to do with psychology.

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Buyback Brouhaha

Optionally Not Good

Share buybacks tend to divide investors between those who love them and those who positively abhor them. The latter tend to come with the view that finding and holding stocks that offer outstanding long-term returns is hard enough without managements surrendering that value in order to artificially boost stock prices.

It turns out that company managements are generally very keen on stock buybacks because they’re linked rather closely to executive remuneration schemes and, in particular, the scourge of all investors everywhere – executive stock options. Nearly everywhere you find significant buybacks you also find large scale stock option schemes and as managements take away from shareholders with one hand they reward themselves with the other. Nice work if you can get it.

The Logic of Share Repurchases

Share buybacks or repurchases occur when a company either goes into the market to buy its own stock or tenders for it, off market. The shares are taken out of circulation and the earnings-per-share of the company goes up – same earnings, less shares. As a shareholder you might well think that this is a good deal – and it may be, but it isn’t always. Often, isn’t.

Although short term earnings per share goes up – and the share price will generally follow to keep the price-earnings ratio stable – the company is, in fact, investing its precious earnings in non-producing assets. The whole idea of a corporation is that it takes its excess earnings – its profits – and invests them to generate growth in future and, therefore, increase earnings. These higher earnings, if no more stock is issued, will automatically and organically generate higher earnings per share and share prices.

Future Earnings Failures

If, however, the company spends its excess earnings on its own stock it’s not investing in its future. Occasionally this may be a valid thing to do – if the company is trading at a very low price in relation to its real value and it has excess cash that it can’t deploy for one reason or another then it makes sense to engage in buybacks because this is rewarding long-term shareholders, who will end up with more real assets for their money, over short-term shareholders, who will be selling out. Of course, these aren’t characteristics common to the modern corporation.

As usual Warren Buffett said it best. Back in the 1999 Berkshire Hathaway annual shareholder’s letter he waxed large on stock repurchases:

“There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.”

The point is that if a company is selling in the market below its intrinsic value (see Is Intrinsic Value Real?) and it has the free cash available to make repurchases then stock buybacks make sense. Otherwise they don’t – buying shares in the market at more than they’re really worth makes no business sense whatsoever. It punishes long-term shareholders whose earnings are being deployed in a value destroying way.

In fact the only people who benefit from such actions are those who are intending to sell in the very near future, who are likely to get the artificial boost of a rise in the share price. Given that those people who want to exit the shareholder register should be near the bottom of management’s interests and the fact that most buybacks tend to happen at prices in excess of intrinsic value this suggests that there’s something odd going on.

Management Logic?

There are multiple possibilities as to why managements might behave in this manner. One, perfectly straightforward reason, is that they’re probably not very good at figuring out the intrinsic value of the company they’re responsible for the stewardship of. At the best of times this is a difficult calculation and in some industries it’s simply impossible because the lack of forward visibility shrouds any reasonable estimates in billowing clouds of uncertainty. In fairness managers are paid to manage, not to constantly figure out the real worth of their company. It’s just a shame they often can’t do either.

It’s also a curious anomaly that repurchases are common when stockmarkets are flying high and stocks highly valued and rare when they’re not. Again, possibly, there’s a rational reason for this – in times when stockmarkets are doing well management may feel particularly, if irrationally, confident in the future and feel obliged to find a way of deploying earnings rather than simply putting the cash in an interest bearing account somewhere. In any case the shadowy figures that run the securities industry tend to punish such actions: they reckon that such cash should be handed over to them in the form of fees for value diluting acquisitions.

So maybe, sometimes, repurchases of shares are based on factors other than managers’ personal self-interest. Certainly that’s what the managements will tell us, only the actual numbers imply something different. The actual numbers appear to suggest that managements are using stock repurchases to game the system and undermine shareholder value.

Management Greed

If we go back to 2007, a time that can now clearly be seen to have been a period of stockmarket overvaluation, US corporations spent nearly one trillion dollars on stock buybacks – roughly two thirds of net earnings that year. That’s an astonishing amount of money, most of it spent on overpriced stock.

In “Accounting Rules? Stock Buybacks and Stock Options: Additional Evidence” Paul Griffin and Ning Zhu have looked closely at the relationship between stock buybacks and CEO compensation and have found some interesting and suggestive correlations. Firstly they find that buybacks are a reliable indicator of share price movements. Unfortunately stock prices usually move down, not up, in the six months after a buyback.

Secondly the research finds that the decision to make a buyback and the amount of money deployed in the buyback is reliably correlated to the CEO’s stock option plan. All things being equal, the more stock options the CEO has the more likely the company is to engage in a really large buyback, regardless of the intrinsic valuation.

Not accounting for buybacks

There are a whole range of possible reasons for this behaviour including, of course, that the correlation is spurious. However, what seems to have happened is that the change in accounting rules on stock options around the turn of the century, forcing the recognition of earnings per share dilution caused by in-the-money options has led to an equal and opposite reaction – the use of company money to retire shares from the market. The buybacks, in essence, balance out the negative effect on earnings per share of stock option cost recognition.

Partly, the authors speculate, this is because of weak accounting mechanisms around buybacks which allow managements to avoid transparency on the issue. The resulting impact on the share price suggests that shareholders aren’t really fooled. Although this isn’t definitive it also suggests a reason why managements prefer stock buybacks over dividends – dividends dilute earnings per share, buybacks don’t.

Perverse Games, Again

All of which suggests – surprise, surprise – that managements in general and CEO’s in particular are gaming the system to their own advantage and against that of their investors. In general buyback companies tend to be smaller, in more leading edge industries and have significantly larger stakeholders on their boards. The lesson is that investors looking for long-term value should be extremely wary of companies with these characteristics because they may be diluting shareholders’ long-term gains in favour of their own short term benefit.

Of course, these are trends we’ve seen before. Developing perverse incentives to game the system is what most humans do given half a chance: it’s called self-interest, it was one of Adam Smith’s guiding principles and it’s both legal and perfectly predictable. However, rewarding such behaviour with our money is to play the wrong game. Stock options are nearly always a lousy way of aligning management and shareholder interests: investors should minimise their exposure and maximise their own self-interest wherever possible.


Related Articles: Perverse Incentives are Daylight Robbery, Correlation is not Causality (and is often Spurious), Gaming the System

The Business of Capital is Bust

Investment Bankers Aren’t Hairdressers

In a recent Financial Times article one of their feature writers opined that the main problem the world has with investment banker bonuses is jealousy rather than the unfortunate fact we’re going have to sell our children to pay off the debt their antics have mired us in. She goes on to expound on how these monetary geniuses offer unique services that deservedly command huge fees by way of an extended metaphor about hairdressers who are able to charge £300 for a haircut that doesn’t require blow-drying for a quarter. I have a local barber that does the same for £295 less. It’s called a crew cut.

The discourse of jealousy is rife in financial circles at the moment, it being an easy way for poor put-upon bankers to justify and defend themselves to themselves. The reality’s more complex and deserves a properly serious treatment because investment banking is a vital function in the modern world. The business of capital needs a proper defence, not half-baked childish psychological theories which merely justify the status-quo and irritate the hoi-polloi without addressing the real, underlying problems.

Good Capital, Bad Capital

If we needed evidence of how important the business of capital is to our economies then the problems of the past couple of years, when the availability of investment capital has suddenly been choked off, should be sufficient. Without massive, free flows of capital our world doesn’t function very well and those people who are able to create, manage and direct those flows are incredibly important. Whether we like it or not such people will make vast amounts of money as they levy their tolls on the passing financial traffic.

However, there’s good capital and there’s bad capital and it’s fiendishly difficult to tell the difference (although when it’s directly borrowed from taxpayers at century low interest rates it’s a bit easier to spot). Unfortunately the downside of the creation of bad capital takes time to become clear and if we reward the purveyors of it in the same way as we reward the managers of the good stuff we create perverse incentives for quick-rich merchants to dig a huge financial black hole for taxpayers to backfill – see Perverse Incentives Are Daylight Robbery and Gaming The System for a more extended discussion of this.

It’s inevitable that those people able to generate huge amounts of capital will come in for a certain amount of opprobrium since they’re the embodiment of the destructive processes of capitalism. They oft-times make huge fortunes by destroying the livelihoods of others but, in so doing, open up new investment and business opportunities that would otherwise have languished in abeyance due to the lack of investment capital. That’s capitalism for you – the guys in the black hats win every time but the Lone Ranger gets to trade in Silver for a T-Bird and a winter condo in Florida.

Michael Milkin, Capitalist Hero

Take Michael Milkin, the junk bond trader who eventually spent time in a US penitentiary for securities violations. Milkin is popularly regarded as the embodiment of greed and as an essentially destructive force. His ability to raise huge quantities of capital was a major factor behind the rise of the leveraged buyout (LBO) which saw many well known businesses getting taken over by sharp pencilled financial specialists whose main aim was to generate excess returns on previously moribund capital by gearing up balance sheets to generate yet more capital for further corporate actions.

Ultimately this process extended into so-called ‘greenmail’ where potential takeover victims found themselves on the end of phantom takeovers where the aggressor was able to use Milkin’s promise to raise capital to fund the takeover as leverage to force capital reconstruction. In common parlance this meant that the target companies had to take on debt to return capital to shareholders – including the greenmailers.

Efficiency at the Point of a Knife

While all of this is vaguely unsavoury and clearly impacted ordinary workers in the target companies, many of whom lost their jobs as a result of the efficiency improvements needed to fund the corporate activities, there is an economically important benefit to such actions. Done properly these types of activities release capital tied up in old, inefficient and slow growth businesses to invest in new, efficient and high growth ones. Arguably without Milkin there’d be no internet. Unfortunately, once a financial bandwagon starts rolling it’s hard to avoid every greedy copycat in the vicinity jumping on board.

So it was with LBO’s as the levels of leverage being applied to takeover victims grew steadily higher and higher. With such mounting debt came ever more dubious justifications from the investment industry, ending with the analogy that excessive debt made managers more careful, like a driver with a dagger mounted on the steering wheel, pointing at their heart. As Warren Buffett wryly observed, that just means that the smallest pothole is fatal. So it proved of the most highly geared companies. And Michael Milkin, hero of the capitalist system, went to jail.

Excessive Gearing

It’s in the nature of the business of capital to overreact in this manner and the system of incentives that lies behind it is a major factor in these swings. By rewarding the creators of bad capital just as heavily as the creators of good there’s every reason for every individual to chase the capital dog to the very limit – which usually means the creation of excess gearing.

The breakdown in world finances that the world has suffered since 2007 is largely due to the investment banking industry finding ever more creative ways of generating capital. We saw in It’s Not Different This Time that the excess returns made by banks since the early 1990’s are almost entirely attributable to increases in leverage of their balance sheets rather than a reward for skillful and intelligent risk taking. Which is what you get when you reward people for generating capital without regard for its pedigree.

An Anthropologist on Wall Street

Part of the problem for the financial industry is that it deliberately sets out to generate insecurity, because in movement and instability lies opportunity. If there’s no corporate activity then there’s no money being generated. This insecurity drives to the very heart of the investment business as the individuals within it seek to maximise their returns in the minimum time available, before they themselves are reorganised.

As Karen Ho, in her anthropological study of Wall Street, has observed, this restlessness translates into the need to create corporate instability outside of the financial industry and has major implications for workers in industries with no experience or capability of dealing with the levels of insecurity this causes. The ordinary employee simply doesn’t have the skills to cope with the type of seismic change that investment bankers habitually live with.

Greedy and Responsible?

It’s little wonder that when the folks on Main Street think of investment bankers it’s not as the lubrication that makes the free, capitalist world go round but as a bunch of overpaid, greedy and remote technocrats with little understanding of the real world. Which is probably not too far from the truth, even if it’s a bit one-sided.

However, the business of capital is far too important to the world to leave it at that. The investment banking industry needs to reform itself from within: there are no people better situated to flag the difference between good capital and bad and to create incentivisation schemes that differentially reward the purveyors of each. A socially responsible capital creation industry is probably a bit too much to hope for, but a system of delayed incentives based on the generation of real returns as opposed to simply rewarding the creation and movement of capital will go a long way towards creating an industry and a global economy subject to less inherent instability.

Reform or Be Reformed

It’s already clear governments are going to enforce changes which, mostly, will end up damaging the capital generation capabilities of the world. This is because, external to the industry, no one can differentiate between bonuses for good capital and those for bad – so you get a “one size fits all” solution which suits no one and will lead to subdued global growth for years to come. The natural inclination of the denizens of the world of capital creation is to grab as much as they can now, ignoring the fact that this money has been spirited away from consumptive children, poorly puppies and impoverished pensioners to prevent an even greater crisis.

For the sake of the industry, and the world, it would be better if the investment banks addressed their own problems rather than simply moaning about the irrelevant jealousy of the masses because, unless they do, the business of capital will be bust for a generation. The world can do without £300 hairdos but it can’t survive without good investment banking: it’s time to take a razor to both.


Related Articles: Moral Corporations: An Oxymoron?, Hedge Funds Ate My Shorts, Gaming The System, Perverse Incentives Are Daylight Robbery, It’s Not Different This Time

Disclosure Won’t Stop A Conflicted Advisor

Monetary Conflicts

Nowhere are conflicts of interest quite so common as in the financial industry. Accountancy firms want to provide consulting services, credit rating agency employees want to work for security analysis firms, independent security analysts need to ensure their recommendations don’t lose their employers important mandates, financial advisors want to get commissions for recommending products … the list is almost endless.

The popular answer to these problems is almost always the same – disclosure of the conflict of interest so that the purchaser is fully aware of the potential problem. Unfortunately the reason that disclosure is so popular is that it doesn’t work. Even worse, it may actually make the problem worse.

Corruption’s Not The Problem

Let’s start this sad catalogue of problems with an important caveat. In almost all instances the problems caused by conflicts of interest between personal interests and professional ones are not cases of corruption. Of course there are some advisors who are blatantly dishonest and who deliberately oversell their products but these are relatively few and far between and besides aren’t the topic of our investigation. No, our bunch of conflicted advisors are driven by internal demons that are far more difficult to pin down. These are unconscious side-effects of various psychological biases rather than deliberate acts of criminal intent.

In the end most corrupt advisors get rumbled – although as Bernie Madoff has shown, this may take an awfully long time. The problem with the honest ones is that they’re still chiselling us yet would be able to fool a lie detector or, worse, their wives, without the slightest difficulty. Meanwhile the methods used to protect us from these practices may actually make things worse.

Disclosure or Regulation?

The most popular remedy to conflicts of interest is disclosure. The idea is that if the advisors, of whatever hue, declare their conflicts then we, the purchasers, can make a clear sighted call about whether the advice we’re being given is in our best interests. However, we can almost immediately identify two problems with this. Firstly, if we were really able to make such decisions then we wouldn’t need to consult an expert anyway. Secondly, even if we do adjust our behaviour to take account of the conflict we have no guarantee that the advisor won’t adjust theirs to take account of the fact we know about the conflict.

And if you didn’t get that don’t worry. We’ll get back to it soon enough.

The alternative to disclosure is often regulation, making the disclosed behaviour illegal. Mostly the affected parties prefer disclosure since this avoids them having to give up whatever they’re disclosing and also means that all parties don’t have to adjust to a difficult new reality. However, the idea behind disclosure is actually pretty dubious: it shifts the responsibility for making informed decisions from the (supposedly) knowledgeable advisor to the (usually) uninformed client.

The Dirt on Coming Clean

Cain, Loewenstein and Moore investigated this whole area in The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest and anyone really interested in this topic should peruse the source material as it’s impossible to do it justice in a short article. It’s a very fine piece of research.

They took the basic idea of disclosure into a laboratory setting and set about developing an experiment to investigate its effects on advisors and clients. By comparing advisors’ own personal estimates with the advice they actually gave under different conflicted situations they found that:

1. If advisors don’t have any conflicts of interest their advice is unbiased;
2. If advisors do have conflicts of interest but don’t disclose them then their advice is biased;
3. If advisors do have conflicts of interest and do reveal them then their advice is even more biased.

Trying to disentangle the various threads involved in this is tricky but two possible explanations have been proposed. The first is simply that the disclosure of conflicts of interest leads advisors to assume that clients will discount their advice, so they increase the bias in their advice to compensate. The second is that the disclosure frees the advisor from guilty feelings about violating professional norms and this so-called “moral licensing” leads to more bias.

There was another problem, though. Although clients discounted their advisors’ opinions when the conflict was disclosed this was insufficient to offset the bias. Which led to even less accurate decisions than when the conflict was undisclosed.

Clients Are Also Conflicted

So this is a two-way street: clients are also affected by advisor disclosure, only not necessarily in the way you might expect. Other research has found that disclosure doesn’t necessarily deter clients from accepting advisors’ advice and may actually have the opposite effect. Two underlying biases seem to be implicated in this. Firstly we have a tendency to delegate difficult decisions to experts – so, for instance, we generally accept the opinions of our doctors without ever asking for a second opinion (a mistake, by the way). So the fact that we’re being told that the expert has a conflict of interest often doesn’t make much difference – the expert is the one in charge.

Secondly, the disclosure inadvertently seems to trigger a response that works along the lines of “if they’re told me about this conflict then that shows that they’re honest and if they’re honest then I should trust them more”. The fact that the honesty has been forced upon the advisor by a legal requirement to make the disclosure is irrelevant, it seems. It’s the disclosure that triggers the response.

Expert Evaluation of Expert Disclosure

Possibly the biggest problem, however, is that a disclosure of a conflict of interest by an expert often requires an expert to evaluate it. If you go to a doctor about a difficult medical problem and the physician tells you that you need an expensive drug but that she’s being paid by the pharmaceutical industry to plug it how do you respond? Does this disclosure help you make the decision or not?

Well, not, as it happens.

If you can’t trust the expert giving you advice then possibly your only option is to get another expert opinion. However, the evidence from medical research is that people don’t bother. This is possibly more worrying in finance than medicine. As Bill Bernstein has said:

“The depressing fact of the matter is that the federal and state governments do not protect investors in the same way that they do the clients of other professions. Amazingly, stockbrokers are not considered fiduciaries at all, as are practitioners of all other learned professions. This state of affairs is, in some respect, a historical accident.

All the professions I’ve mentioned, except finance, have long since recognized that regulation of minimal standards of training and practice is a necessity. It happened, for example, to the medical profession a century ago with the publication of the Flexner Report. Bluntly put, there’s no chance that your doctor, dentist, or attorney is a high-school dropout. Your stockbroker, however, just might be.”

After all, what is a financial expert anyway?

You Get What You Pay For – One Way Or Another

Disclosure’s a lousy way of fixing the kind of problems caused by conflicts of interest. It seems that business models that rely on promoting such conflicts are fundamentally flawed because they’re bound to trigger this type of behavioural confusion. In fact, wherever you find a situation where disclosure is mandated you should automatically assume that you’re at risk from these types of unconcious bias. As my grandmother used to say: you get what you pay for. Even if you don’t know you’re doing so.

The research says, that when it comes to advice, especially in financial matters, it’s always safest to pay directly rather than indirectly. Alternatively, get a second opinion.


Related Articles: You Can’t Trust The Experts With Your Investments, Bulletin Boards Are Bad For Your Wealth, Survivorship Bias In Magical Mutual Funds

Moral Corporations: An Oxymoron?

Ethical Management

In the wake of the fin de siècle scandals involving Enron and Worldcom came a new focus on business ethics. Most MBA courses these days routinely run courses where bored wannabe rich, thrusting junior executives are preached to about how money is not the most important thing. This situation is rich in comic potential, but one can’t help suspecting that the students are, if they’re paying any attention at all, simply constructing a checklist of how not to get caught.

The problem is that the unconstrained free market seems to encourage behaviour that in the normal context of human life would be regarded as completely unacceptable. Many of the ethical problems of corporations occur when their managers are unable to apply the morality of normal human interaction to that of business life.

Maximising Profits, Setting Incentives

Back in 1970 Milton Friedman argued in “The Social Responsibility of Business is to Increase its Profits” that … well, you can probably guess. His argument was based on the premise that executive officers have no right to spend company money on anything other than maximising profits because to do so is to defraud the rightful owners of the money – that’ll be us, the shareholders. He sets the limit of lawful action at the boundary of corporate law – whatever is permissible in law is permissible in business.

A related argument is that business people will only behave ethically if their incentives – their financial recompense and the strictures of the law – are set so as to ensure that they do so. There’s no need for any concept of ethics in this view – people behave as they’re incentivised to do and if they behave immorally then that’s because the framework they operate in is incorrect.

We’ve had a taste of what happens if these approaches to ethics are allowed to run amok, back in mid-nineteenth century Britain when the free market was allowed to flourish, almost unimpeded by regulation of any kind. By the normal human standards of morality it wasn’t a pleasant experience, albeit one that allowed the dark satanic mill owners to maximise their returns at the expense of a decrease in the average workers lifespan even as economic growth was exploding.

The point is, of course, that we can’t just rely on the argument from incentives or even the attenuated ethical model advanced by Friedman. These systems have obviously never stopped any determined shyster from pillaging the system, from Charlie Ponzi through to Bernie Madoff, nor dubious investments in dodgy regimes or ethically reprehensible policies like selling dried baby food to Third-World countries without clean water supplies. We simply can’t turn the debate about right and wrong over to remuneration committees and legislators.

Immorality is Behavioural

The reason we can make this call on ethical behaviour is that personal and business morality are closely related: we frequently behave unethically outside a business environment so it should be no surprise that we do so inside one. All that’s different is the context – although, as we’ll see, that can make a big difference. You’ll be unsurprised to know that at the root of these problems is a behavioural issue. Simply, we don’t recognise or accept when we’re being unethical. In the encouraging words of Tenbrunsel (1998):

“People believe they will behave ethically in a given situation, but they don’t. They then believe they behaved ethically when they didn’t. It is no surprise, then, that most individuals erroneously believe they are more ethical than the majority of their peers.”

We have multiple strategies for dealing with the nasty reality that we aren’t as honest as we’d like to think. My favourite is our use of euphemism to avoid facing up to unpleasant truths. So “right-sizing” means people getting fired and “downsizing” means people getting fired and “rationalizing” means … Yeah, well, you get the idea.

Travelling Hopefully Not Ethically

In all probability there’s an underlying evolutionary reason for self-deception. People who see the world in a less self-centred manner are given to more frequent bouts of depression: we may simply need to view ourselves through rose coloured glasses in order to survive. The theory is that we’re born liars because we need to be able to convince other people that we’re truthful – and to do that the person we most need to convince with our lies is ourselves.

Regardless, most people’s self-predictions generally reflect their hopes rather than any realistic self-understanding. The more socially desirable the behaviour that’s being predicted the less realistic tends to be the prediction – behaving ethically is, of course, socially extremely desirable. And, of course, people tend to be completely unaware of these biases.

In a business situation we’ll frequently be given a reason to cast our morals aside. Here our natural inclination to self-deception can collide with business imperatives to create the kind of ethical scandal that gets onto the front pages of the gutter press. To prevent this many businesses have introduced ethical monitoring systems to check up on our behaviour. As you’d obviously expect the introduction of such systems has a noticeable effect on ethical behaviour: people start behaving less ethically.

Much, much less ethically.

Framing the Situation

The monitoring systems seem to cause us to “frame” the situation differently. We no longer have to judge for ourselves what constitutes ethical behaviour. We frame the situation as a business one: the cost of misbehaving isn’t an ethical issue but simply a question of price.

A practical example of this was shown by Gneezy and Rustichini (2000) who studied day care providers. The nurseries introduced a fine to encourage more timely behaviour in parents who were persistently late to pick up their children. Naturally this resulted in a dramatic change in parent timeliness. As you’ve probably guessed – many, many more parents arrived late.

The introduction of the fine had changed the frame from a moral one “it’s not right to be late” to a business one “if I’m late it’s OK because I’m paying for it”. So much for financial incentives.

When we take together our ability – even our need – to engage in self-deception along with the tendency to frame business situations in a different way from those of our personal lives it’s not hard to see how business morality can be eroded. In particular when ethical degradation occurs in small steps we’re more likely to accept it – the road to Hell is paved with small transgressions.

Moral Ambiguity Rules, OK?

When corporate leaders fail the ethical test it’s almost always when they get muddled up between business morals and personal ones. Business morality and that of everyday life mustn’t be separated. We should respect the reality that many business decisions are sunk in moral ambiguity without demanding that executives leave their morals at home. Is it right for western clothing companies to pay third-world children a pittance for their labour? Or is it OK that they pay those children an above average wage for their society and ensure they receive a schooling that would otherwise be impossible? And where do we stand when both these situations are the same situation?

Corporations tread a difficult path between profit maximisation and an ethical quagmire. However, a company that encourages its employees to abandon their limited personal morals at the entrance can’t be trusted to tell the truth to its shareholders. Remember that “creative accounting” is a business euphemism, for “we’re lying to our shareholders”.


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Gaming the System

Bankers and Politicians

Using the rules of any system for personal gain is, in the parlance, “Gaming the System”. We’ve seen a lot of this recently. Not only have a variety of financial executives and employees absconded with bonuses for profits that turned out to be illusory but here in the UK the whole political system has been rocked by revelations of the extent to which our elected politicians have been using their expenses system as a personal cash machine.

Charlie Munger states that the people who design easily gameable systems belong in the lowest circle of hell. However, the reason why this happens is rooted very deeply in human psychology and causes all sorts of effects that are bad for us as societies. Those people who invent mechanisms that prevent systems being gamed do us all a favour, and this matters hugely to investors.

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Perverse Incentives are Daylight Robbery

The Wrong Carrots

An awful lot of what goes wrong in the human world is connected to perverse incentives. These are the carrots that leaders use to encourage people to behave in particular ways only, through the law of unintended consequences, they work in more or less the opposite fashion to that intended.

We often misunderstand the nature of incentives because it’s difficult to figure out what they are or even whether they affect us – but if our business leaders get this wrong we see businesses doing extraordinarily stupid things. Worse, if our business leaders’ own incentives aren’t kept in check they themselves do extraordinarily stupid things. We’ve seen plenty of both in recent times and unwinding the mess that badly designed incentives have done to the world is going to take time, patience and thoughtful appreciation of the issues by the world’s leaders, both political and commercial.

So let’s not hold our collective breath, then.

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