David Korn wrote the following (posted with his permission):
"I summarized the salient points of the interview below and included a couple from his prior interview that fit in nicely with the topics he covered.
1. Bob asked Dr. Dan to comment on the efficient market hypothesis which relies on an assumption that the market is rational, and whether it is still valid. Dr. Dan said a critical moment in this discussion was when Greenspan last testified before Congress and basically said, "oops we were wrong." People didn't just assume the market was rational, they assumed it was perfectly rational. Take for example the use of derivatives. Some of the wizards on Wall Street used derivatives to put large sums of money at risk. Dr. Dan pointed out that even if the market is 90% rational and 10% irrational, the moment you take tremendous risk you can create huge devastation if you are wrong. A good analogy is driving. You could be a great driver 95% of the time, but say you are distracted that one time, you could end up killing yourself. That is one of the lessons we have learned in the aftermath of this recession.
2. Why did people take out mortgages that they could not afford to repay? Dr. Dan said we try to find villains, but often the answer is in the nature of human behavior. Dr. Dan said he was at the Federal Reserve for a while arguing with bankers about interest-only mortgages. The people he spoke with felt that interest only loans were great because the consumer could borrow very cheaply and pay off credit card debt with their excess cash flow.
3. Dr. Dan said he was interested in how people figured out how much they could borrow to purchase a home so he put an ad on Craigslist and invited people to come to his office and research houses while he observed the process. What he discovered was that most people simply put in their yearly income into a mortgage calculator and then invariably went to try and get the MAXIMUM amount the lender was willing to give them. Most people had no idea how much to borrow, so they simply went with the most they could get. If we understood how difficult the task was, we would create more complex mortgage calculators and in the wake of the real estate downturn we are starting to see some of that.
4. What caused the financial industry to make such risky loans? Dr. Dan said he has found that many people are able to shape reality slightly and see a reality in a way that is comfortable for them. This goes to cheating. What matters in cheating is to be able to do it and still feel good about yourself. Dr. Dan said he studied cheating in a systematic way. In one of their experiments, they gave people a paper with 20 simple math questions but made them take the test very fast such that it made it more difficult. For one group, they looked at how many answers they got correct, and they were given $1 for each correct answer. For another group, they were told to shred their answers, and then asked them how many they got correctly and they said on average seven. There were a lot of people who cheated just a little bit. Dr. Dan said in economic thinking, all cheating is pre-meditative. Dr. Dan said they modified the experience in many ways, but still nobody cheated a lot, but a lot of people cheated a little. Dr. Dan said people appear to cheat a little up until an amount they are comfortable with. Eventually, they came up with an experiment that made people not cheat. In the experience, they had people contemplate the ten commandments which then put a curb on their cheating tendency. It wasn't that more religious people cheated more or less, it was when the contemplated morality that they curbed their cheating.
5. Dr. Dan pointed out that if you were asked to take a pencil from work versus 10 cents from petty cash, you might feel different. Dr. Dan pointed out that people tend to double their cheating when they are one-stepped removed from real money. Dr. Dan said their experiment suggests that a person who might ordinarily feel morally disgusted at the idea of stealing $100, would nevertheless be willing to back date a stock option as long as they are removed from cash. It is the same with mortgage-backed securities. They are so far removed from money and so hard to evaluate. That makes it easy for us to play shenanigans with them.
6. Dr. Dan looked into the Bernie Madoff scandal and asked what happens to people in a community where they notice that someone else in the community is cheating in an egregious way. It turns out that when this occurs, other people find it much more socially tolerable to cheat themselves. We found this out on Wall Street. If we were in a situation where someone paid us $10 million to sell mortgage backed securities even if we knew they weren't as safe as they were marketed, many of us would sell them. It was hard to evaluate these securities and since there were many different explanations, people would choose the one that worked best for them. And since a lot of people were doing the same thing, it made it easier for people to do. We placed people in a position of tremendous conflicts of interest. We paid them so much money that they had to see reality in a skewed way and then we seemed surprised at the outcome.
7. Bob pointed out that the San Francisco Giants paid enormous amounts of money for a pitcher a few years back ‹ something like $120 million over several years. Bob said the management must have assumed that things would continue along an upward trend but were completely wrong. What is the psychology behind these kinds of decisions? Dr. Dan said the magic number in assumptions relative to behavior and trends is three (3). When something happens for three periods, people think it will happen again after that. So when people hit three baskets in basketball, they think they have a hot hand and will get the next one. This happened with the Internet boom, the Nasdaq and more recently the housing market. It takes very little data for individuals to think a trend is in place and that this time be "different." The stock market is a perfect example where once you have a few years as a sample, people think it will continue and their reaction can perpetuate this even longer. Dr. Dan said people should really try to avoid the fallacy of a trend after three occasions and try to look at larger samples of information.
8. Bob noted that we have over dosed on bubbles lately. We had the dotcom, then real estate. Dr. Dan said we also had the oil bubble in the middle. Dr. Dan said he wasn't sure if we were having more bubbles, or the financial world has changed. Dr. Dan said that the amount of money in the market is larger, the amount of money hedge funds have is larger. What is worrisome is that now that Wall Street is not doing so well, they looking for another method to make money. Dr. Dan said the hedge funds particularly bother him because it is such a crazy system. Dr. Dan said the compensation system has been akin to a dice game where if I roll 1,2,3,4, or 5, we both make money. But if I roll a 6 or 7, only you lose money and I lose nothing.
9. Dr. Dan said if you go to a dentist and they see a cavity in an x-ray, there is only a 50% chance of another dentist looking at that same x-ray and seeing a cavity. Why? Because the first dentist really wants to see a cavity because that is how dentists make the big bucks. Also, x-rays aren't that great an indicator because they have shadows and imperfections. It shows that people make decisions based on what they want to see and on imperfect information.
10. Dr. Dan said recently there has been a lot of discussion about executive compensation and bonuses. There is an assumption that when we pay people big bonuses they will perform very well. He decided to examine that hypothesis with empirical experiments. The experiment went as follows. A group of people were told that if they performed a task well (the task required imagination, creativity, etc. and took about 45 minutes to complete), they would be given the equivalent to what they earn in one day. A second group was told that if they did the task well, they would get two weeks of their salary. Not too shabby for 45 minutes work. The third group was told that they would get 6 months salary if they did the task well! The results were surprising. For the first two groups, the difference between payment of 1-day vs. 2-weeks, the performance did not really change. But when they increased the bonus to 6 months salary, all of a sudden performance went DOWN dramatically. Say what? You would think it would have gone up, but it actually went down. Why? Dr. Dan said the experiment begs the question as to whether the promise of huge amounts of money is actually a performance inhibiter. For example, if you were told you had 25 hours to come up with a really creative story and if you did that you would get $1 million, could you do it better than if you were just asked to do that by a friend? Dr. Dan said that he thinks there is a lot of stress associated with the bonuses and that even though many don't deserve them, they actually can create circumstances where the person won't do well.
Caller: This caller said she has heard people blame the "free market" for the recent problems because it allows for greed and such. But she said how can it really be a "free market" when the government has such control in the system to impact interest rates, and other things? Shouldn't things just be left to take care of themselves? Dr. Dan said there are many examples to show that we are really lousy at managing our best interests. Think about driving. His state passed a law to prohibit people from sending text messages or reading e-mail messages while driving. It makes one ponder what kind of world we live in when we have to pass regulations that simply tell us not to do what we already know is incredibly dangerous. Dr. Dan asked 200 students about this and he was astounded to find that 99% of them send text messages while driving. All of them admitted that they had made mistakes driving while doing that! And they admitted that they were lucky they had not got in an accident. Driving is a good analogy to how we behave. For periods of time we are ok, but for periods of time we screw up big time. When people think about the free market, they tend to think it will all work out even though many of us do not act in our self-interest. Dr. Dan said if you wanted to take out all market regulation and make it a true free market, he thinks you would get the same result as if you took out every kind of driving regulation and let people drive however, they want fast, drunk, whatever. We would not have financial success.
11. Dr. Dan said traditional economists and behavioral economists differ in their belief on the impact people's irrationalities. Traditional economists acknowledge that people make mistakes but say that those mistakes are random and cancel each other out in the market. Dr. Dan says his studies show that the mistakes are not random, they are systematic, predictable and repeatable and for that reason we need to consider them when making policy, decisions, etc.
Caller: This caller pointed out that gambling casinos use chips and not money, and that at the most expensive restaurants don't even list the prices of their food. Dr. Dan said casinos really understand human nature. There is a theory called the "pain of paying." Most people say that paying with cash is much more painful than paying with a credit card and the experience becomes less fun. American Online used to charge by the hour, but when they changed to an all you can use model for a monthly fee, their enrollment quadrupled over night, way beyond their expectations. The moment you don't couple consumption with it costing you for every minute, the pain of paying was eliminated. This happens with casinos. You try to get the purchasing to be separate from the consumption.
Dr. Dan: Bob asked Dr. Dan to comment on why people throw their money away day after day, year after year on lottery tickets which is the worst possible investment ever conceived? Dr. Dan said there is a huge psychological difference between zero probability and 0.00000001 probability. These are not the same and when you buy a lottery ticket, you buy something different than zero and are actually buying hope. A corollary to this is that there is a big difference psychologically between 99.99999 and 100. Many times we over pay for insurance. We could have a very low probability of having something bad happen to us, but we will pay a lot just to make sure that we are covered 100%. If you really want to go into the business that preys on people's weakness, choose nuclear insurance. There is a very low probability of it ever happening, yet because people fear it so much they will pay a lot for it. On top of that, if there were a true nuclear calamity, the insurance probably would never be paid!
Caller: This caller asked discuss what the most important things he learned based on his experiments of people cheating. Dr. Dan said that he discovered people's decisions about cheating aren't about the probabilities of being caught, or even the economic rewards to be made. Instead, it is about our ability to cheat but still be good about it. The moment something is removed from actual money, it becomes more easier for us to cheat. Dr. Dan said with all of the derivatives out there, you wonder how much cheating is going on.
Dr. Dan: The market for home robbery, car theft and arson is $16 billion a year. The insurance industry, however, estimates that they lose $24 billion a year to exaggerated claims. What that shows you is that the losses we are seeing from so-called "criminals", is much less than "honest" citizens who are just cheating a little bit on their insurance claims. An even bigger part of the cheating pie is the in-house theft at companies which is estimated to be as high as $600 billion annually. The amount of money you could lose to a lot of people who are cheating just a little bit can dwarf the amount stolen by the common thief.
Dr. Dan. Bob asked Dr. Dan to discuss his research about the placebo effect. Dr. Dan said he was in the burn ward at a hospital for a long time, and what always amazed him was when people were crying with pain, the nurses injected some patients with nothing but a placebo, and they immediately fell asleep. Placebo for pain is real. If you think something will work, your body will create a reaction and your body will produce something that is the equivalent of morphine. When you have a reason to doubt that the painkiller will work, you will actually get less out of the painkiller, even if it is real.
Caller: How would you recommend making better decisions on buy and sell decisions? Bob interjected that when the stock is at record highs, people aren't concerned, but when the market is down as it is now, people get fearful. Dr. Dan said whenever emotions get involved, this is not a good time to make a decision. Emotions were designed for behavior long ago. For example, when man lived only in the jungle, our emotions told us to run when we saw a tiger. There was no thinking about whether this was a good or bad idea, and thus our emotions served a valuable purpose. Today, in the stock market, emotions are a bad thing. Dr. Dan thinks you should create a set of rules that sets how your investments should look, what your strategy should be. Type those up and when your emotions get happy, or fearful, look back and check out your strategy and try to follow it because you made that list when you were in a calm thinking state."
[David Korn's Stock Market Commentary, Interpretation of Moneytalk (Bob Brinker Host), Financial Education, Helpful Links, Guest Editorials, and Special Alert E-Mail Service. Copyright David Korn, L.L.C. 2009]
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