Tuesday, December 23, 2008

Hard wired to deceive?

As the Madoff story runs its course and investors express surprise and shock that they were taken to the cleaners, it may be worth noting that research in the social sciences suggests that this may be par for the course, given our genetic make-up. Here is the evidence:

1. Brain size and potential for deceit are correlated: Studies of primates have uncovered an interesting finding. The larger the brain of a primate, the more likely it is that it will indulge in deceitful behavior. The great apes, for instance, are masterful deceivers but as the primates with the largest brains (arguably), human beings are at the top of this deceitful heap... And smart human beings are much better at deceiving others than dumb human beings!!
Bottom line for investing: You are at greatest risk of being lied to, when you invest with the smartest portfolio managers (hedge funds?)...

2. We lie and we do so habitually: A study that tracked students (by inviting them to keep track of their lies in a journal) uncovered the fact that they typically lied about two times a day.
Bottom line for investing: The standard investment sales pitch contains more than its share of half truths.

3. We do feel guilty when we lie, but that does not stop us from lying again: The same study that uncovered the fact that students lie two times a day, on average, also found that while they felt guilt at doing it, the fact that they were able to get away with it reinforced the behavior. Put another way, if you get away with lying once, you will will try it again...
Bottom line for investing: All the ethics classes in the world and forcing everyone to attend religious services every week won't stop the next big fraud or even reduce its likelihood.

4. We often want to be lied to: Here was the most interesting conclusion. The researchers who have looked at this phenomenon and noted that it has been going on for as long as we have been on earth have determined that, deep down, we want to be lied to. In some cases, this is because the truth will hurt too much (That dress does really make you look fat) and in other cases, because the lie makes us feel better (You are brilliant!!!)..
Bottom line for investing: Every fraud has two players - the fraudster and the victim. While we tend to think of the former as the villain and the latter as the victim, they need each other for it to work.

So, take the
talk that you hear about this being the fraud to end all frauds with a grain of salt. This has happened before and will happen again... why? .. because we are human!!


arnav said...

Can't agree more... All your points from social sciences theory are very apt in this case

Another key point why such fraud happens (...more of economic theory) is due to information asymmetry - which occurs when the seller knows more about a product than the buyer - This is esp true in case of retail investors (& charity funds in this case)..Often garbed in financial service industry especially hedge funds under fancy terms (like split conversion strategy by madoff)

i believe regulators, and audit authorities, can play a big role by
a) making information readily available (read more disclosure norms for hedge funds)

b) Drive to reduce gobbledygook language from financial disclosure reports,products prospectus etc so that investors can comprehend it. even financial media can help here.

this might help a bit ?

Aswath Damodaran said...

I wish that this would help, but I don't think it will make a dent. In these instances of fraud, it is amazing how many of the victims are sophisticated investors... And the perpetrators of these frauds are not necessarily more informed, just more adept at bending the truth.. After all, what Madoff knew about stocks, options and investing would have fit on the head of a pin.

Unknown said...

I believe government, and any authorities as well, are only supposed to complement functions of the market where the latter meets the failure. There was no failure of the market in the situation we talk about – just the investors who haven't asked "right" questions.
Anyway try to remember Gödel's incompleteness theorem. In general it says that there is no perfect formal description of the system - every time the understanding is more important. - I don't try to be mathematically correct here, but still the understanding which comes through additional questions and personal talk (not prescribed by the authorities!) are the only things the investor can rely on.

Sharvani Pinge said...

I specifically liked the fact that when you are cheated, it means you let that happen to you.
Tali kabhi ek haath se nahi bajati.. True in every walk of life.

Krasen Yotov said...

I like the 4 th point. Investors want to believe they can get double-digit returns with no risk involved.