Todd Pinkerton

*ok, so maybe it’s still partly about economics. But a recent talk by Dan Ariely shed some light on the quirky, human aspects of our financial decision-making. 

A few days ago I saw Dan Ariely speak at MIT as part of the Media Lab’s Center for Future Banking.  The Center is sponsored by major banks like Bank of America,  so in that context Ariely spoke about his research and how it relates to the current financial problems we’re facing. 

Ariely is known as a ‘behaviorial economist’, which is to say he studies how people relate to money.  I’ve been following his work for a few years now, but recently he’s been getting a lot more attention for his book Predictably Irrational and regular NPR radio series. 

So Ariely’s big thesis is that we incorrectly assume people behave rationally, always acting in their own self  interest and maximizing their personal gain. As a society we enact policies that assume these economic principles.  For example, we increase penalties as crimes get bigger, because we assume people will weigh the risk vs. reward and decide the increased jail time is not worth the payoff. 

But reality is different. People do not always behave rationally, especially when money is involved.  And here is where we get to the current events surrounding the ongoing financial meltdown.  

Ariely’s experiments show that people will cheat or steal, but how much they steal is not determined by external factors as much as it is upon our own self-image.  We steal as much as we can as long as we can look ourselves in the mirror.  As much as we can rationalize, as much as we can justify stealing that is how much we will.  

One experiment involved having participants complete a quiz, and then self-report the number of completed answers.  The participant was then paid $1 for each answer.  It was obvious one could cheat; the question was, would they and how much? 

The control group averaged 4 completed questions, worth $4.  The test group averaged $7, implying that they self-reported 3 more questions than they actually deserved.  Test subjects were also more likely to cheat if someone (an actor) obviously cheated from the start — they would just follow his lead and cheat in the same fashion, as if the actor was validating their actions.  

Another test tried substituting tokens instead of cash.  The idea was to see if people are more likely to steal if they are stealing things that do not remind them directly of the monetary value of what they are stealing. Tokens, credit card numbers, etc. As it turns out, Ariely’s experiment shows that people are more likely to steal the tokens — which they can exchange for cash just a few feet away — than they are to steal the cash directly.  It is more abstract, we can rationalize it to ourselves easier, and we can deny that it is really stealing anything of value.  

How this applies to Wall Street is pretty obvious. Take executive compensation, and the back-dating of stock options.  Stock isn’t real money (although it can be sold immediately and electronically for cash in your bank account), so that becomes easy to rationalize.  Stock options aren’t even stock, they are a ‘right’ to purchase, so that is even easier to rationalize as a non-valuable good.  And in the case of back-dating options, we’re not even talking about executives stealing or giving themselves more of those — just changing the dates around a little.  In this light, we can see how executives who engage in this illegal practice can justify and defend these actions as “not really stealing”.

Other psychological links to the financial world: 

• People want to see the banks that made poor lending decisions suffer — even if it means they have to hurt themselves (by paying) in the process. 
• Business students are taught how important diversification is, and yet still concentrate a lot of their own worth into their own company’s stock — like Bear Sterns, which later collapsed.