ContentsCritique of Daniel Kahneman - Decision Making Theories ..............................................................
Critique of Daniel Kahneman - Decision Making TheoriesThat‘s a very bad heading but I could not think of anything else.Wha...
context/surrounding events before anyone has to decide which option to choose. The responses I am sure willbe exactly norm...
Loss aversion says that suggests that the displeasure of losing a sum of money exceeds the pleasure of winningthe same amo...
okay looms very large. Overweighting of small probabilities increases the attractiveness of both gambles andinsurance poli...
Well I am looking at the rear view mirror with a 20/20 hindsight right?? Here are some really low probability risksand I w...
Flow Chart of System 3 decision Making                                                                   Start            ...
Proposal of System 3System 1 and System 2 are very good at explaining almost all the thinking and consequent behaviors sho...
Factors Influencing Thinking and Decision Making Under RiskFor financial decision making particularly by bankers, traders,...
A Banker gets a loan proposal to approve or disprove a loan of a No income No job homeless guy in            2006.        ...
Relating Superior Orders to actions of Subprime Loan OfficersI will say many people in banks who approved the crap loans t...
CEO/MD of S&P, Fitch, Moodys has directed juniors to rate these crap loans as AAA then it shall happen. ItsAlice in wonder...
But he would do exactly what Milgram got it done for his experiment. Obedience to authority almost alwaystrumps any ration...
particular kind of decision which the juniors alywas obey no matter how stupid/conflicted/wrong those decisionsbe in eyes ...
Now comes the most difficult part to reconcile with our normal notions of normal people. Do people enjoy inflictingpain? O...
The foreclosure guys were ready to do completely illegal things like fraud and forgery to appease/obey theirmasters. As th...
Anybody guessing how come the Superiors think about ordering those egregious policies read no further thanabove 3 instance...
incentives) are incomplete. Again I am not talking about a coin toss and whether you want to choose to win orlose $100 or ...
Recent Historical Evidence effect on Decision Making1968-72 – Tech industries and 70+ p/e when Warren Buffett closed his p...
it means that behavior of peer companies will be mindlessly imitated by others no matter how wrong they may be.This means ...
Behaving the way others have behaved in the position—Zimbardo ExperimentThis may not be intuitively clear when you have re...
Do you know any instance where a junior person refused to do a job in big bank because it was too risky orillogical or did...
put on the CEO Corzine (who incidentally earlier was Goldman CEO). My bet is this on Mr. Corzine . He willNEVER EVER be co...
―Let‘s try out a novel idea: Banks that help drug cartels launder money and give cover to those tied to terrorismshould be...
You will get 20% of the profits.        You will NOT have to share even a penny of loss.        Suppose whole invested mon...
From 2000 though 2008, Mozilo Countrywide CEO received total compensation of over $500 million.Read more: http://business....
From the list you can see apart from GM n Chrysler and maybe some other small company all bailouts were forFinancial Indus...
How do Bankers make DecisionsP- 315How do people make the judgments and how do they assign decision weights? We start from...
Financial risk taking_theory
Financial risk taking_theory
Financial risk taking_theory
Financial risk taking_theory
Financial risk taking_theory
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Financial risk taking_theory


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I have put together this Factors Influencing Thinking and Decision Making Under Risk . Basically I have used Milgram , Zimbardo theories and combined them to show how financial firms today make decisions because brilliant as they are Mr. Daniel Kahneman's theories don't come close to explaining the reality .

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Financial risk taking_theory

  1. 1. ContentsCritique of Daniel Kahneman - Decision Making Theories .........................................................................................2 My Hope to Explain Real Life Decision taken under Risk.......................................................................................3 Arguments against Loss Aversion when applied to Bankers and Money Managers ..............................................3 Arguments against Certainty Effect ........................................................................................................................4 Arguments against Possibility Effect .......................................................................................................................4 Importance of Conditions/Situations in Decision Making ........................................................................................6Flow Chart of System 3 decision Making ...................................................................................................................7 Proposal of System 3 ..............................................................................................................................................8Factors Influencing Thinking and Decision Making Under Risk .................................................................................9 Incentives and Superior Orders ..............................................................................................................................9 Superior Orders and its Importance in Financial Decision Making .................................................................. 10 Million Dollar Incentives and its Effect on Decision Making under Risk ........................................................... 16 Recent Historical Evidence and behaving the way others have behaved in that position: .................................. 18 Recent Historical Evidence effect on Decision Making .................................................................................... 19 Behaving the way others have behaved in the position—Zimbardo Experiment ................................................ 21 Other People‘s Money at Risk - OPM .................................................................................................................. 24 How Questions on Decision Making under Risk Should be Asked .................................................................. 24 Implicit Govt/Central Bank Guarantee and Easy waiver by Paying Fines ........................................................... 26 How do Bankers make Decisions ........................................................................................................................ 28 Arguments Against Denominator Neglect ............................................................................................................ 28 Framing Effect Disproved .................................................................................................................................... 29 Real Life conditions before Framing Question ................................................................................................. 30 Conclusion ...........................................................................................................................................................
  2. 2. Critique of Daniel Kahneman - Decision Making TheoriesThat‘s a very bad heading but I could not think of anything else.What is evil -- ―Evil is knowing better but doing worse ―Mr. Daniel Kahneman (the Nobel winner) is one the most amazing thinkers of modern era who has justcompletely changed the way we look at the world and the decisions taken by people in the world. His brilliantbook ( ) is a 20 times read. Youcan just keep reading again and again and again – discovering new things every time you do that. It makes youunderstand why probably you took a decision when ideally/rationally you should not have done so. So why thecritique post??Well having read the brilliant book Thinking Fast and Slow by Mr. Daniel Kahneman I noticed something strangein every single question he had ever asked for framing his theories mostly related to monetarygambles/chance/risk taking. They will NOT apply completely to the thousands of Bankers, Traders, Lenders,Insurance Sellers (who are or should I say were too big) --who are taking decision under risk. The reason thetheories will NOT apply is NOT because decisions are complex or theories completely wrong or they are usingSystem 1 instead of System 2 but because the crucial elements (situations/conditions) are almost alwaysneglected in almost all questionnaires for any psychology/logic tests undertaken by any researcher.I searched for several of his articles and the references he himself used for writing those and I could not find themost important factors which affect decision making under risk in real life organization/situation.The choice of picking a decision using rational calculations or System 1(intuitive) based on prospect theory orwhatever is secondary to the conditions surrounding the decision making. The conditions surrounding decisionmaking are NEVER extraneous or too unimportant in real life.This analysis will look at the financial risk taking while showing that prospecttheory( cannot explain the decision making in financial world todaywhen complete picture of conditions which leads to reckless risk taking is taken into account i.e. the incentives(bonuses), Superiors‘ orders, managing other peoples‘ money, too big to fail and implicit guarantee from allCentral Banks around the world that you will be saved even if you completely screw up (the whole firm orconsequently even the economy).I would love if Mr. Daniel Kahneman applies all his theories of decision making to the bankers and financialindustry as we know today to show how effectively it predicts the actual actions of these Lords of Finance. I amsure the theories cannot be applied to decision making of bankers which have brought terrible misery to millionsaround the world and amazing riches to bankers and financial institutions.(if you do not believe this stop reading!!)I argue that what happens in REAL world more than 99% of the time when real people (almost all in some sort oforganizational set up) are taking real decisions in organizations which can be observed by anybody is notexplainable completely by theories like prospect/certainty effect/loss aversion/utility/System 1 or 2, etc.I am not a professor who can catch 50 students and give them a sheet of paper with 5 logic questions (each with2 choices) and then extrapolate them to real life decision making. I will ask the same questions which have beenasked in the book Thinking Fast and Slow at the end of the write up. The only difference will be – I will
  3. 3. context/surrounding events before anyone has to decide which option to choose. The responses I am sure willbe exactly normal as what happens in real life but the responses will violate most of the existing theoriesregarding decision making under risk.My Hope to Explain Real Life Decision taken under RiskMy hope is to explain the way real life choices are taken by individuals who have the maximum effect on thesociety (like bankers). Unfortunately when I look at the decisions taken by individuals under risk (most of them inan organizational setting) then the System 1 or System 2 or prospect theory or certainty effect DOES NOT seemto be able to explain even 20% of the decisions actually taken. Almost all of the crucial decisions impactingTrillions of Dollars and Millions of human beings cannot be explained using prospect, certainty, possibility or lossaversion effects or expected utility theories. While someone may actually say that whatever I have written isbasically behavioral finance/economics but I would disagree because it is not just about behavior but thinking-action and the disconnect between what is expected based on current theories to what actually happens in reality.Nowhere would I say that any of the theories are wrong. It is just that what you observe in real life cannot beexplained using the theories available either by Bernoulli ( or by Mr. Kahneman. I am not aware of other theories which may explain the actual decisions but what I will tryto do is use the already available research/psychology theories (standing on the shoulders of other giants—wink--rather than trying to re-invent the wheel) and try to relate them to what I have observed in last 15-30 years infinancial industry. The responses to choices people make are inconsistent with rational choice or loss aversion orprospect theory or certainty affect and other theories which are in existence.Mr. Kahneman proposes correctly – after framing of questions those decision-makers, prior to evaluating the iprospects, perform an editing operation that collects similar outcomes and adds their probabilities. After thatthey actually evaluate the prospects using rational choice. This is really helpful when individuals (who are NOT inany organization setting) are taking decision. But it fails when we try to extrapolate them to financial institutions ofthis world.What I propose is this (related to decision makers in fin institutions) – Even before editing operation or evaluationof prospects decision makers ALWAYS use their System 3 to understand 4-5 basic facts/conditions whichsurround almost every decision making, more so in finance.These can be briefly summed up as - Superior Instructions , Incentives and Threats, Managing other people‘smoney , Too Big to Fail - Guarantee from Central Banks/Govt (aka privatizing the gains and Socializing thelosses) that you will be saved no matter what you do.I hope some real academics pick up something from my writings to make a more comprehensive theory ofdecision making under risk which can be applied to real life financial institution without just using words like moralhazard or short term thinking.(Wherever I have written Page Number or P- XYZ it refers to page number of the Book Thinking Fast and Slow.Please do not sue me- I am not rich !!!)Arguments against Loss Aversion when applied to Bankers and Money ManagersLoss aversion ( will apply only to the individuals whose own money is atrisk. It is almost useless to apply loss aversion theory on Thousands of bankers (including Central Bankers) andmoney managers who do NOT risk their own money but instead manage/move other people‘s money. And evenin worst case scenario will not lose something which they already have but rather they may not get somethingwhich they may have
  4. 4. Loss aversion says that suggests that the displeasure of losing a sum of money exceeds the pleasure of winningthe same amount. True when money from your own pocket is on the line.But what if this is not the loss from your pocket/bank account?? What if winning the bet means you will surelypocket bonus but losing the bet will NOT decrease your already huge fixed salary/upfront commission??Losingthe bet may make you to get lower bonus. Will the loss aversion principle still apply with the same accuracy??Does the banker feel same pain as you feel when both lose money? Does the banker or money manager say/feel– OOOOhhh losing a $billion dollar was so painful but winning a $billion was OK??Of course not. If you are managing someone else‘s money then Loss Aversion does not apply completely. Infactcompletely something like gain fondness is in work while managing other people‘s money. Bankers and moneymanagers jump up and down and will/do take crazy risks with other people‘s money. No Loss aversion if it‘s notyour money. SIMPLE.Arguments against Certainty EffectFrom his book -- ―Demonstrate that outcomes which are obtained with certainty are overweighed relative touncertain outcomes. In the positive domain, the certainty effect contributes to a risk averse preference fora sure gain over a larger gain that is merely probable.In the negative domain, the same effect leads to a risk seeking preference for a loss that is merely probable overa smaller loss that is certain. The same psychological principle-the overweighting of certainty-favors risk aversionin the domain of gains and risk seeking in the domain of losses.‖ is surely in true negative domain because most fin industry does take risk in that way. But I am not sure if it iscorrect in positive domain.What is a sure gain for a bank?? (Borrow at 3% ie deposits and lend at 6%, right?? You are certain to makemoney this way. ( ) heck ya bankers indeed used to do this.Try telling 3-6-3 rule to Jamie Dimon and you will have a proof that certainty effect cannot work completely in reallife organizational setting when these factors are taken into account.Don‘t you think that 3-6-3 rule is almost certain and other trading; derivatives gains etc are merely probable?Don‘t you think that exactly opposite happens with bankers where in positive domain they go for more risk takingfor gains which are mrerely probable rather than going for sure gain which is lower?If answer to any of above question is yes Certainty effect is obviously not correct when applied to bankers.Then why do you think all banks keep on doing all kinds of trading, derivative activity to generate their profitswhich are much more risky and merely probable rather than just do normal banking which is almost a sure gainbut lower gain?It is because certainty effect completely fails when conditions surrounding the decision making are taken intoconsideration. People use System 3 which goes against certainty effect.Arguments against Possibility EffectPage 303- Because of the possibility effect, we tend to overweight small risks and are willing to pay farmore than expected value to eliminate them altogether. The psychological difference between a 95% risk ofdisaster and the certainty of disaster appears to be even greater the sliver of hope that everything could still
  5. 5. okay looms very large. Overweighting of small probabilities increases the attractiveness of both gambles andinsurance policies.The conclusion is straightforward: the decision weights that people assign to outcomes are not identical tothe probabilities of these outcomes, contrary to the expectation principle. Improbable outcomes areoverweighted—this is the possibility effect.P-303The large impact of 0 5% illustrates the possibility effect, which causes highly unlikely outcomes to beweighted disproportionately more than they “deserve.”Well if someone in 2005-06 said don‘t you think that housing prices might go down? I mean you are AIG who isselling insurance , CDS of more than $200 billion(they got bailed out by getting something around that $+/-20billion) betting primarily on single assumption that Housing prices will not go down all at once . The probability ofhouse prices going down was surely not 0. It was miniscule but not ZERO. So possibility effect says – improbableoutcome (house prices going down) should be overweighed.How many people or institutions do you know paid too much money to eliminate this miniscule probability ofhouse price decline?? I know--- don‘t use the brilliant book ―The Big Short to rattle off the names.I mean this is called as Mr. Daniel has put – theory induced blindness. Possibility effect is completely proven to bewrong when put in real life situation where the factors which are surrounding decision making are neglected.Here are few examples: Rating agencies just did not have models where they could input house price declines. Didn‘t they use System 2 while rating almost trillions of dollars worth mortgage and bonds most of which turned from AAA to CCC within a span of 3 years. Could you as a business man selling insurance have stood up in say 2006 and said – Hey according to possibility effect you should pay too much money to protect yourself from house price decline. Hey Mr. Lehman Bank why don‘t you buy an insurance I am selling and it‘s priced at 10 times than what AIG is selling because I have read Thinking Fast and Slow.Infact possibility effect is completely turned on the head (sorry to say completely wrong) when applied toinsurance selling by AIG and billions of CDS selling by every single financial institution. They priced the insurancefor a low probability event TOO LOW. People (99.99% of them) actually completely sidelined the small risk ofhouse price decline. Everyone except some really smart guys. Go read Big Short. Possibility effect says completeopposite. It says people should overweight the small chance of disaster.Ok so do you differ on what disaster means?? Well you just have to have been through 2007-09 to know what adisaster really means. If people did completely opposite to what possibility effect says they should do why is thereno paper written on the erroneous possibility effect?? I could not find anything which even remotely tries to relatepossibility effect to any financial disaster. If the possibility effect cannot be applied on the financial organizations itshould be made clear that -- Please apply possibility effect only when individuals are making decisions whichconcern only them and there are no context/situation/conditions surrounding the decision making – ie decisionmaking is being done in a complete vacuum . Then Possibility effect is fine.Else please go through these factors which are a must when you try to explain why every body completelyneglected a small probability event and nobody was prepared to pay even a penny to insure against a smallprobability of house decline. You can easily sequentially decipher and relate to the decision making by ratingagencies, bankers and insurance
  6. 6. Well I am looking at the rear view mirror with a 20/20 hindsight right?? Here are some really low probability risksand I would ask you to answer some questions: Japan defaulting on its bonds. ( ) US govt defaulting on its bonds.(Russia did this in 1998) US dollar replaced as the world‘s reserve currency.(remember pound was reserve currency till late 60‘s) US govt confiscating Gold and gold prices jumping stratospherically. (During Great Depression it happened) You have life insurance and motor insurance but have you paid any thought to having some kind of portfolio insurance for the money/stocks/bonds you have against a calamitous decline?All these are NON ZERO probability events. Do you think buying protection is cheap (because no takers) or isexpensive (too much demand)? Do you think people are overweighting this miniscule chance of the above eventsand paying exorbitant prices for buying insurance against them? Do you think the insurance companies arepricing protection policies against the above elements at a very high relative level?If you will use certainty effect and possibility effect you go completely opposite to what is happening here in reallife. Use this method instead.All this is rather obvious, isn‘t it? You can easily imagine Mr. Kahneman to construct similar real life examples andtrying to say that well these are cases when Possibility effect and certainty effect does not work i.e. real world bigorganizational based cases. But for some reasons he didn‘t.P- 268 If you come upon an observation that does not seem to fit the model, you assume that there must be aperfectly good explanation that you are somehow missing. You give the theory the benefit of the doubt, trustingthe community of experts who have accepted it.Well I don‘t do that.Importance of Conditions/Situations in Decision MakingConditions/Situations surrounding a financial decision making are more important factor to determine thedecision making under risk than the actual evaluation of choice. Ignoring situational factors in any decisionmaking theories is next to ridiculous. Most economists who do not want situational factors to come in their typicalquestionnaire type experiments and hence cannot explain how most real life decisions under risk in this world aretaken will say – ―That can happen in practice but never in theory ―. iiDaniel Kahneman has brilliantly put in his book Thinking Fast and Slow and various papers that in decisionmaking there are two phases in the choice process: a phase of framing and editing, followed by a phase ofvaluation (Kahneman and Tversky 1979). The first phase consists of a preliminary analysis of the decisionproblem, which frames the effective acts, contingencies, and outcomes. Framing is controlled by the manner inwhich the choice problem is presented as well as by norms, habits, and expectancies of the decision maker.Additional operations that are performed prior to evaluation include cancellation of common components and theelimination of options that are seen to be dominated by others. In the second phase, the framed prospects areevaluated, and the prospect of highest value is selected.All of above is fine except when applied in real life when people are taking decisions in organizations.Human beings decision making process (in absence of these factors) will always follow what Mr Daniel hasexplained in his book brilliantly. Unfortunately in real life rarely is decision making choice presented to a personwithout these factors
  7. 7. Flow Chart of System 3 decision Making Start Some Question on Decision Making under Risk Is decision being taken in any kind of Organization? Yes NO System 3 (Conditions surrounding Decision Making are Always More Important) For Financial Decision Making CompaniesIncentives and Superior Recent Historical Other People‘s Money Implicit Govt/Central Bank Guarantee Easy waiver by Orders Evidence (Herd Instinct) at Risk Paying Fines Use System 1 or 2, This is where Framing effect ,Prospect theory, Loss Aversion, Certainty Affect, Experienced utility Endowment effect, Utility Theory(all Taking into account the ‗conditions/situations’ economists‘ theories) etc is applicable . surrounding decision making take a decision and try to show as if you are using logical/rational/System2. People bad at Take a decision which can be easily manipulating facts fail in institutions. explainable by above theories. Stop
  8. 8. Proposal of System 3System 1 and System 2 are very good at explaining almost all the thinking and consequent behaviors shown byhuman beings.In short System 1 is good at making quick intuitive everyday decisions where you do not have to really stop whatyou are doing and think. Rather the answer comes just naturally/quickly (though that does not mean it would becorrect).Typical decisions taken by System 1 - an experienced driver navigating a busy street.System 2 is much deeper level of thought like multiplying 17x34.Best explanations provided here vast majority of crucial decisions in this world related to at least financial matters do NOT comeunder either System 1 or System 2 entirely. I will give lots of examples later in brief of decisions related tofinancial industry which prove that System 1 and System 2 are not the comprehensive theories which explainwhat happens in real world when people choose to make decisions.I love this part from Mr Daniel‘s Book - P-306 we took on the task of developing a psychological theory that woulddescribe the choices people make, regardless of whether they are rational.In the same way I propose that crucial financial decisions (by people in fin organizations) point out to some otherSystem of decision making which is more dominant/important than System 1 and System 2 ---ie System 3.Existence/Use of System 3 by human beings can be explained when the conditions surrounding a decisionmaking become more important than the framing of choices or of actually evaluating the decision/choices.In the following part of my write up most examples I will give will revolve around financial industries decisionmaking of late 21st century.If you as an investor can find out using my above factors/flowchart/conditions which banks/investors are usingcurrently to make decisions and find out that they may be doing mistakes. Then you can take opposite view andoutperform. Here is my favorite ‗mentor‘ Howard Marks on Mistakes. it requires the investors to understand what is going through with other guys at big banks and completelyindependent thinking from the
  9. 9. Factors Influencing Thinking and Decision Making Under RiskFor financial decision making particularly by bankers, traders, insurance sellers (like CDS sellers), fund managerswho handle other people‘s money and have incentives most of the questions put forth in the book regardingfinancial losses and gains MUST be preceded with at least these 4 conditions(not necessarily in order): 1. Incentives and Superior Orders: Your incentive/bonus is almost completely dependent on you taking the gamble (and winning of course just as so many around you have been recently doing with ease) and you also have been directed by your seniors (a.k.a. superior orders plea) to take the gamble though you can fight back, look lonely/stupid in short term and choose other option. 2. Recent Historical Evidence (Herd Instinct), Behaving same way as others previously have done and got away with: For the last 2-5 years people (colleagues who have made millions and have been promoted) and your competitors have been choosing alternative X (which is gamble, neither a sure thing nor a 98%+ probability event) have actually won and made tons of money, got lot of power, bought big houses, fast cars, beautiful girlfriends/wives and traveled around the world. If you become a banker you have full freedom to screw your clients just as others before you have done consistently and got away with huge bonuses. 3. Other People’s Money at Risk: You are not putting your own hard earned money at risk but putting other people‘s money at risk. The rewards will be yours and losses will be borne by someone other than you. You can never have a negative bonus but only reduced even if you completely blow up OPM (other people‘s money). 4. Implicit Govt/Central Bank Guarantee and Easy waiver by Paying Fines: If the whole firm blows up or even economy blows up Central Banks will print money and Save you just as they have previously saved big banks and even hedge funds like LTCM if you are too big to fail. Or if you indeed are caught you can settle by neither admitting nor denying wrongdoing.Only after all these 4 conditions are specified the normal questionnaire with an option X and other options shouldfollow to test the rational decision making of individuals who are working in financial services industry(even inother industries or public life). Some cases would seem just as moral hazard as an already existing theory forexplanation of a lot of decisions I will explain but moral hazard does not take into account Superior Orders. Andany case I have yet to see a theory which explains decision making which gels well with decision making underrisk and combine it with moral hazard and System 1 and System 2 kind of thinking.Here are my reasons for putting each of these 4 conditions for any model which seeks to understand decisionmaking under risk.Whenever a I say a person in Financial Industry it should indicate that I Want to collectively point out to fllowingpeople - bankers, traders, money managers, lenders ,Insurance Sellers , Analysts, Economists(directly involvedwith Wall Street).Incentives and Superior OrdersThe most important factor which is taken into account while making a financial decision by a person in financialindustry is Incentive and Superior Order. The use of brain, knowledge, experience, rational thinking or intuition etcall come at a second place when crucial and critical decisions are made.The first consideration when following people get following choices is how will their bonus/salary get affected andwhat direction has been given the by his superior . The decision to choose an option is almost already takenbased on incentives and Superior Orders. The people just have to justify somehow why they chose X over Ytrying to look as logical/rational as possible.
  10. 10. A Banker gets a loan proposal to approve or disprove a loan of a No income No job homeless guy in 2006. Money Manager Gets an opportunity to choose between a McDonalds stock or a CDO squared. Insurance Seller like AIG decides to insure against default by AAA rated subprime bond by selling a CDS. Analysts decide to put a buy rating for NASDAQ stocks when P/E was 150+. Economists/Professors try to predict the future macro or micro events before or after crisis.This discussion is not about trying to predict manias/bubbles and make money or avoid losing money because Ihave benefit of hindsight and the people did not have it. This is about something like a System 3 in human brainwhich takes decisions(lot of times completely irrational) when incentives and Superior Orders are combinedtogether to make a powerful force which almost always shuts the System 1 and/or System 2 easily in almost allpeople involved.Superior Orders and its Importance in Financial Decision MakingThe decision making under risk should ideally be using System 2 and use rational/objective reasoning to arrivebased on available facts. Unfortunately that happens in theory or really less number of times in practice. Most ofthe times any decision making under risk put forth in front of a person in financial industry comes implicitly with adirective from Superior as to what choice should be taken before the person in charge has had a chance to usehis rational/knowledge/experience to objectively take a decision on it.I will try to explain this with the famous Milgram experiments ( a must read) whereby ordinary people administered life threatening shocksand pain to other people just because they were in an experiment and wanted to please the experimenter byobedience to his orders. I will NOT explain the exact experiement but anyone can read about it by googling it.I will use the material from and try to relate to kind of decision making which has happened in financialindustry over the years and try to show why System 1 and System 2 thinking are inadequate/incomplete whenapplied with Milgram‘s findings and why a System 3 actually works in these cases when a Superior has orderedsomething.Assumption- Imagine that instead of choosing to give shocks to the ‗learner‘, in real financial world the choice fordifferent people were following – giving a loan to absolutely derelict borrower with no income and no jobs , ratingCCC group of subprime bonds as AAA , analysts putting buy rating on a stock with no earnings at a valuationwhich is laughable by any stretch of imagination during IT boom, choosing a CDO squared asset class to investretirees pension fund money ,etc or to back out .From Milgram’s experiement:“Many of the people were in some sense against what they did to the learner, and many protested evenwhile they obeyed. Some were totally convinced of the wrongness of their actions but could not bringthemselves to make an open break with authority. They often derived satisfaction from their thoughts andfelt that -- within themselves, at least -- they had been on the side of the angels. “In other words perfectly rational and smart people abdicate their will to make rational, intelligent and objectivechoices and thus their autonomy (and System 2) when faced with a Superior Order situation. They then useSystem 3 to take
  11. 11. Relating Superior Orders to actions of Subprime Loan OfficersI will say many people in banks who approved the crap loans to no income people knowing fully well that the loanjust cannot be paid out in any circumstance, did what people did in the experiment. The loan approvers who didcredit checks or risk management teams who approved the kind of subprime loans almost surely knew whatwould happen but they could NOT say NO when their superiors told them to approve the loans. They had to usetheir System 3 of brain to do things like Robo Signing, incomplete document based loans, loans to derelict people,etc. They would have derived satisfaction from their thoughts using System 3 and felt: within themselves at leastthey are giving a person a place to live. Even if a loan officer was totally convinced of wrongness of action hecould not bring himself to make an open break with authority/senior that we should NOT loan money to thisjobless guy.There were 3 things why they could not defy authority – bonus/salary , threat of losing job and act ofobedience to superior . The experiment has proven that even when there was absolutely NO threat to job/life,there was not enough incentive in cash form, no pride in succeeding but just participation in a simple experimentstill people went that far.Hence it would be futile to expect that normal run of the mill people working in big banks doing credit checks andapproving loans would use their System 1 or System 2 to think through and take a rational, independent, objectivedecision which goes against – Superior Orders, Incentives and a probable job loss/no promotion .This is exactlywhere System 3 comes into picture.It‘s a proven fact that seniors starting from CEOs were jumping up and down and commanding people to give asmuch loan as possible which forced lower officials to use System 3 of brains to give loans without properdocumentation (aka robo signing scandal), risk assessment and complete disregard to any rationalthinking(System 2) .System 3 seems to be that part of decision making which takes into account the inherent trait of obedience ofpeople to authority which compels them to do tasks/work which they would NEVER even dream of doingindependently or would never do if they would use their Rational (aka System 2) brain. ------ Everybody must see the documentary Inside Job Superior Orders to actions of Rating AgenciesIn short rating agencies screwed everything up. How CCC did rated bonds come together to magically becomeAAA which pension funds would. There were less than 10 companies which were AAA but thousands of crapbonds rated AAA which of course investors lapped up happily and faced consequences. The actual people whowould go through the process of calculating the risk of default of CCC or other complicated CDOs etc are reallyvery smart and intelligent (read great System 2). Most would be finance majors or statistics major or Phds etcfrom top US and world universities. ( . How could all of them together rate something as AAA which became CCCin next 3-5 years?? Was all of their System 2 so bad that they could not conjure up a scenario where home pricesmay decline?Of course NOT. At least some of the very intelligent and smart people giving the ratings obviously knewsomething was wrong and maybe AAA was not the correct rating for loans which were pooled together. But theyjust could NOT withstand the Superior Order (read orders flowing directly from top officials CXOs etc for Moody‘s,Fitch, and S&P). The ratings approvers could not use their System 2 to go against their immediate superiorsimplicit order to give great ratings to crap securities.There was almost NO question of actually evaluating independently and objectively the bundled securities andrate them. System 2 was relegated to secondary place and System 3 took charge. Thy cannot displease thesuperior order (not just because of fear of job loss or losing bonus) but just OBEDIANCE. If Milgram has proventhat ordinary people under superior order can inflict life threatening electric shocks to unknown people then if
  12. 12. CEO/MD of S&P, Fitch, Moodys has directed juniors to rate these crap loans as AAA then it shall happen. ItsAlice in wonderland to expect juniors to turn against the superiors and hope that they can counter this wrongdoing. Infact just as Milgram experiment proves people felt happy they obeyed this is exactly what happened hereas well.System 3 was completely in work during 2004-07 in all rating agencies except Egan Jones.Relating Superior Orders to actions of Insurance Company like AIG―It is hard for us, without being flippant, to see a scenario within any kind of realm or reason that would see uslosing one dollar in any of those transactions.‖ -Joseph Cassano, conference call with AIG investors, July 2007Fact –AIG recived almost $182 billion to be rescued from hell. The above statement perfectly captures what Mr.Cassano would have been directing his lieutenants to do when the juniors had to take decisions to sell/writeinsurance (guarantee in case of default) and CDS contracts on the crappiest of the bonds and companies. AIGwas happily ready to pay in case of default in return for premiums for various insurance and CDS contracts. Againthe people who decide to insure against a default risk are the top Statistics, Actuarial, Finance Majors, Mathsexpersts from top notch universities around the world. They are NOT your normal dumb people. How could theyblow up so spectacularly??On Page 303 of Book Thinking Fast and Slow Mr. Daniel Kahneman writes:―Possibility and certainty have similarly powerful effects in the domain of losses… Because of the possibilityeffect, we tend to overweight small risks and are willing to pay far more than expected value to eliminate themaltogether….. Overweighting of small probabilities increases the attractiveness of both gambles and insurancepolicies…..Improbable outcomes are overweighted—this is the possibility effect”Unfortunately in financial world particularly during boom times exactly opposite tends to happen because thePossibility effect ignores the fact that human beings behave completely differently while using System 3. AIGactually completely underweighted Small risks (housing price decline) and was ready to sell insurance far cheaplythan what it ought to have done. If you think I am wrong think about $182 billion bailout. The guys who boughtCDS paid far less than what they ought to have paid to eliminate the small risks .But why???One of the reasons is again people (insurance decision makers/underwrites) using System 3 in presence ofstrong Superior authority. When the then insurance ‘GOD’ Mr. Cassano tells the whole world --―It is hard for us,without being flippant, to see a scenario within any kind of realm or reason that would see us losing one dollar inany of those transactions.‖ Do you think that the lowly junior staff members who are actually deciding to sellinsurance would dare to go against the authority??? Would you stand up Against Mr. Cassano, THE MR.CASSANO??Imagine yourself to be the best Statistics, Acturial, maths expert with a spreadsheet to decide whether to insurethis piece of crap bonds (rated magically AAA from CCC). And your top lieutenant just made above command towhole world. What instruction you would have directly got from him or your immediate superiors??Would it be Hey Mr XYZ here is a new bond you have to decide to insure? Use your System 2 or System 1 ofbrain , take a objective , rational decision independently and give a decision – Yes or NO for insurance ??Or would it be – Here is something you have to do – Say yes and we will write insurance for this bond. Our Headhas instructed it, declared openly to whole world. Just do it without giving too much of trouble to your brain.What part of thinking would that junior staff would have used? Not System 1 or System
  13. 13. But he would do exactly what Milgram got it done for his experiment. Obedience to authority almost alwaystrumps any rational decision making and this is exactly what happened with AIG as well. This would happen inevery single company or any institution .System 3 forces people to take completely irrational decision which theywould not have taken had they not been under an order from authority. Possibility effect completely getssidelined. The actual decision to use rational brain to choose whom to insure and at what premium rate getscompletely sidetracked in presence of an order from superior like Cassano.From Milgram’s Experiment ConclusionThe situation is constructed so that there is no way the subject can stop shocking the learner withoutviolating the experimenters definitions of his own competence. The subject fears that he will appeararrogant, untoward, and rude if he breaks off. Although these inhibiting emotions appear small in scopealongside the violence being done to the learner, they suffuse the mind and feelings of the subject, who ismiserable at the prospect of having to repudiate the authority to his face. (When the experiment wasaltered so that the experimenter gave his instructions by telephone instead of in person, only a third asmany people were fully obedient through 450 volts). It is a curious thing that a measure of compassion onthe part of the subject -- an unwillingness to "hurt" the experimenters feelings -- is part of those bindingforces inhibiting his disobedience. The withdrawal of such deference may be as painful to the subject asto the authority he defiesI would suggest you to read the above conclusion again and if needed again. What clearly comes out is thathuman beings are just not as defiant as probably they need to be. They become miserable when they have to goagainst the authority or superior orders.Can the juniors in Financial Institution Ever Stand up to his Superior/CEOThe situation in experiment relates directly to situation in modern fin institutions. Nobody in any fin company canstand up to his superior/CEO without in a way questioning his own competence. Everybody working fear that theywill appear arrogant, untoward and rude if he starts using his System 2 resources the it is supposed to be usedfor. They use System 3 so that they do not have to appear defiant, alone, rude, stupid and lose bonus, jobs,promotion blah blah. The actualWith regards to experimenter giving instructions in person or via phone I think financial decision making wouldrarely change because a email , a quick phone call is all that is needed ONLY ONCE to force juniors to oberytheir seniors. The experiment needs constant encouragement and prodding by the experimenter and hence thephysical presence is so necessary. But in real life financial institutions decision making process the juniors justneed a small email or one simple conference call to clearly give exact kind of decision which they are supposed tomake using the System 3.Once the CEO and board decides to pursue a particular a way for the company the actual System 2 or theemployees down the ladder gets almost suspended .The questions which comes infront of the employees are NOT like multiply 17x34 or Subtract 448-39 whiledriving or a Linda Problem ( .These are questions which haveexactly 1 answer which is correct and no opinions .The questions which face real life people in financial decision making position never have exact one correctanswer. But the CEOs and senior people prod , push , order the lower ranked ones to move towards
  14. 14. particular kind of decision which the juniors alywas obey no matter how stupid/conflicted/wrong those decisionsbe in eyes of juniors.Juniors become absolutely miserable when they have to rate a crap CCC bond as AAA or sell CDS at priceswhich are laughable or give buy ratings to companies like Juniors own System 2 decision making partwhich should ideally be working fine because they are really smart people (all decision makers in financialindustry are highly qualified with degrees from top notch univ) does not work when they are under adirection/superior order. They are forced to use System 3.Can the juniors actually stand up to MDs and CEOs and say NO? Yes but in rarest of the rare circumstance theywould go to defy authority in his face. The Unwillingness to hurt the superiors is just too strong a feeling foranybody, exactly the way Milgram has proven it to be.Once you add other factors its well neigh impossible to use your rational decision making brain, knowledge, orSystem 2 to take a decision, Factors like: Your job, your promotion, your bonus, your salary depends on you obeying your seniors‘ orders.A person they suspends his System 1 and System 2 decision making process and uses System 3 to somehowprove that seniors orders are correct. Countless models are changed/constructed and backtracked after putting afinal value (as decided by seniors) so that it seems plausible with explanation.Valuing a company with no earnings?? NO problems just put something like a 50% growth in revenue and a 50%decline in costs for next 5-10 years to make sure that the final valuation for the company comes close to what youhave been told to show. I have seen valuation models which assume a 45% CAGR Net Profits for 15 years for acompany. Bingo you have released a research report with a price target so that your investment banking divisioncan now peddle that to raise more money via IPO or secondary issue. You as an analyst is going to beappreciated in front of everybody. You just used your System 3 to avoid confrontation and show deference toauthority disregarding your own System 2 and power to choose.Rating a crap CCC bond??How to make it AAA?? Use your statistical knowledge, use lots of Greek letters, makecomplicated models and assume that Home Prices never go down, no recession in future, etc. Bingo you havemagically transformed a group of CCC bonds into AAA. And your superiors will give you high fives. (Along withloads of money as well).In the experiement when there was no one around, no threat to job, no negative incentive, no embarrassmentinfront of people, not much incentive still people administered life threatening shocks to unknown people. Thepoor people who work in financial industry at least didn‘t do that but just obeyed what their master told in a highfunda way whereby they could defend what they did using some complex methods/calculation with sometimesreally ridiculous assumptions .From Milgram‘s experiment:Duty without conflictThe subjects do not derive satisfaction from inflicting pain, but they often like the feeling they get frompleasing the experimenter. They are proud of doing a good job, obeying the experimenter under difficultcircumstances. While the subjects administered only mild shocks on their own initiative, oneexperimental variation showed that, under orders, 30 percent of them were willing to deliver 450 voltseven when they had to forcibly push the learners hand down on the
  15. 15. Now comes the most difficult part to reconcile with our normal notions of normal people. Do people enjoy inflictingpain? Or were they basically sadist, psychopaths who just happen to work in normal jobs? The answer as pointedout by experiment is NO.Subjects like the feeling they get from pleasing the experimenter. If there could be one sentence whole ofHR classes in MBA have to teach this should be it. Even when there was no great incentive or threat orchallenging work in the experiment still people like to please their superiors. Imagine what magical thingssuperiors can get the juniors to do when order can be combined with incentives, threats, etc. All you need to do isto somehow invoke the feeling which most people inherently have relating to pleasing superior and obeyingauthority.They are proud of doing a good job, obeying the experimenter under difficult circumstances. They are notworried about shocks to poor learner but they are more concerned about obeying the experimenter. They useSystem 3 which can completely disregard System 2 rational thinking part.So does anyone think that bankers who have created such a havoc all around in last 3-5 years are going to takeeven an iota of blame for doing what they did?? Even Eichmann did not take blame but kept on saying he wasdoing what was ordered to him.The bankers who did robo signing or approved crap shit loans (Countrywide is perfect example of those kind ofpeople ) were actually proud of doing a good job at that time , obeying their superiors and giving ‗homes‘ tohomeless(of course pocketing huge bonuses as well). Without of course knowing or acknowledging the fact thatthey were not using their rational brain or System 2 but rather using System 3 which loves deference to authority.Milgrams Experiment and Foreclosure Scandals Banks ready to pay $26 billion tocompensate for improper foreclosure practices. Now this is REAL. And believe me when banks finally decide topay for something wrong they have done that something is REALLLLLLLLY BIG.In short what happened is this – Banks made crap loans to all and Sundry. Bankers made bonuses had parties,enjoyed a lot. 2008 all hell broke lose. House prices declined and loans were more than value of houses. Sobankers again did what they do best – CEOs directed juniors to go rampantly on foreclosing procedure. Laws bedamned. Rules be ignored. Documents, signature, procedures can be fraud. Seniord didn‘t care. They wantedforeclosures and juniors obliged by doing whatever illiegal they can.There are countless cases going in court regarding the complete mess of robo signing where one individual wouldsign on 500+ foreclosure papers a day without any regard to logic, rules, morality, thought or anything remotelyrational and legal.Why did the junior most officers do this??Again the people who have fraudulently and illegally evicted thousands of homeowners by peddling/signing fraudforeclosure papers are NOT inherently bad/sadistic or want to push pain on poor homeowners (most who havelost their jobs). None of the bank officials are people who lack System 2 thought process. They are perfectlycapable of taking a decision to evict a home owner from his house should be taken by duly following theprocedures and having correct documents. But when the orders from superiors aka the CEOs (Big SwingingDicks) comes they cannot disprove/disobey the authority precisely the way Milgrams subjects could not
  16. 16. The foreclosure guys were ready to do completely illegal things like fraud and forgery to appease/obey theirmasters. As they say –―we were just following the orders‖. I will say they were using System 3.They know that they are going to cause immense pain to the homeowners and their families but its not that badas disobeying the seniors is. When without incentives people in Milgram‘s experiment were ready to almost killothers giving shocks these bankers were just, you know following orders and in a way taking home away frompeople who could not afford to pay mortgage anyway. This is how they would justify their actions to themselves.The people who did fraud for foreclosure did so as a sense of obligation to the superiors and company (whichhave given them salaries) orders, an impression of their duties as a banker/foreclosure officer, showing theircompetence for the job. Not from any peculiar sadistic/cheat/forger/fraud tendency.People do not use System 2 while taking decisions where their superiors have almost already made them choosewhat they need to choose. Rational part of the brain stops working and System 3 takes over. Then people likebankers will easily do fraud signatures, sign 500+ foreclosures (like Linda Green) per day, etc. Its all normal afterSystem 3 takes over.Amazing Part of Milgram’s ExperimentThe 40 psychiatrists who were asked how many people will administer full 450 volts – their answer was 1%.Reality was almost 60-80% of people readily administered the max killer voltage to the hapless victims. Theexperts on human behavior were absolutely wrong because they ignored the situational/conditionsdeterminants of the behavior in the process description of the experiment.Hence any theory of any decision making under risk MUST consider the situations/conditions surrounding thatdecision making. Else that theory must be really limited in scope and outright wrong/useless in real life wheremost people make biggest decisions.Million Dollar Incentives and its Effect on Decision Making under RiskI could write a book on incentives but there are already too many theories and books available that I will sparerepetitions and just go straight to disproving System 2, rational thoughts, prospect theory, loss aversion, certaintyeffect, etc.Bank Profits Bonuses $1 $10 TARP Govt Million million Bailout Bonuses bonuses Money billionsBank of $4.00 $3.30 172 4 $45AmericaCitigroup ($27.70) $5.30 738 3 $45Goldman $2.30 $4.80 953 6 $10JPMorgan $5.60 $8.70 1,626 10 $25Merrill Lynch ($27.60) $3.60 696 14 $10Morgan $1.70 $4.50 428 10 $10Stanley•Countrywide Financial (now owned by Bank of America) founder and CEO Angelo Mozilo cashed in $122 millionin stock options in 2007; His total take is estimated at more than $400 million dollars.• Stanley O‘Neal, who steered Merrill Lynch into financial collapse before it was taken over in a shotgun weddingwith Bank of America in 2008, was given a package of $160 million when he retired.• Bear Stearns former chairman Jimmy Cayne, rescued by a $29 billion Fed shotgun wedding to JPMorganChase, and received $60 million when he was replaced;
  17. 17. Anybody guessing how come the Superiors think about ordering those egregious policies read no further thanabove 3 instances. If you want to read more Google ‗compensation Wall Street CEO ‗, You won‘t be disappointed.Apart from the actual cash in TARP here is some more ( pay at the banks in 2010 was about the same as in 2007, before the bailouts.Now I do not want to get into discussion with anyone whether pay is high or low but I guess it is reasonableincentive. When all hell broke loose Fed Reserve printed money like hell and lent almost for free $7.7 trillion to thebankers.And their bonuses and salaries have not gone down as much as most would have expected.So the age old question of decision making under risk stands tall – Does incentives have too much of affect onactual decision making??Does actual act of decision making or fear of loss gets completely washed away when you have only upside butthe downside can be easily spread across public??Does privatization of profits and socialization of losses indeed change the way decision making under risk isdone??Does normal theories of decision making still apply to these big banks which know for sure that they are going tobe saved by Fed Reserve??(If someone says they were not saved please read the above BBG article againwhere Morgan Stanley took $107 Billion yes Billion with a B and Bank of America took $86 billion ...I can go onan on )Again I will start with my most important point – How do human beings use their brain to choose betweenoptions when huge incentives are present which explicitly nudge them to choose one and reject other??I am talking about all big REAL life decision making and not some $100 or $200 gain or loss on a coin flip during aleisurely walk in the park. I am talking about a million dollar in bonus or go home kind of situations.Its amazing that Mr. Daniel‘s book Thinking Fast and Slow has mentioned incentive word just 8 times. In decisionmaking or thinking to solve a problem when different choices are present I think the most important factor has tobe incentive, particularly for thousands of bankers who move money.―You‘re going to make an extra $2 million a year – or $10 million a year – for putting your financial institution atrisk. Someone else pays the bill. You don‘t pay the bill. Would you make that bet? Most people who worked onWall Street said, ‗Sure, I‘d make that bet.‘‖ - Frank Partnoy, Inside Job.See the great explanation of power of incentives by Charlie Munger (Vice Chairman of Berkshire and partner ofWarren Buffett) Well I think I‘ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and allmy life I‘ve underestimated it(incentives). actual logical, rational thought of choosing an option is almost always secondary to the incentives (or threats)dangling infront of people and hence the theories which try to strip all conditions of real life decision making (
  18. 18. incentives) are incomplete. Again I am not talking about a coin toss and whether you want to choose to win orlose $100 or $200. I am talking about the decisions taken by the Lords of Finance when they have incentivedangling in front of their eyes and some choices to be made. short it says this – If you are a mortgage trader you had a chance to get huge bonus (and your superior as well)if the bet paid off. If you lost the bet and firm lost money you will not receive bonus at all. Maybe you can land aprincely severance package and land up at another firm.But in no case there would be a ―negative bonus‖. In other words you will personally not incur the cost of tradingblow up in any circumstance. Its guaranteed.If ―Economists call this a moral hazard problem‖ I can only smile.On Page 323 –in 2007 no banker had personally experienced a devastating financial crisis.I don‘t know a single banker CEO who had an age less than 45 years in 2007. If someone knows please let meknow because as far as I know you cannot have a Bill Gates or a Zuckerburg in Banking. My questions –Do Bankers need to personally experience a financial crisis to know that they should NOT do X?Did a banker need to experience a fin crisis before deciding to give loan to a No income No job person?Do you need to get fired from a job to know that getting fired is not a pleasant experience?Do you need to personally be in an accident to know that driving at 30 KM/Hr is much safer than driving at 80km/hr ??With compensation in financial companies back at 2007 levels is this what a personally experience of adevastating financial crisis looks like ??Now that all bankers have experienced a fin crisis all is going to be well before all these experienced bankersdie/retire and completely fresh NEW bankers come in?? (Mathematically it should take around 40 years, and Iwould love to bet against anyone under the sun that next fin/banking crisis will take that long)How is it that after almost every 8-13 years there is a banking/financial crisis?Recent Historical Evidence and behaving the way others have behaved in thatposition:All bubbles and manias and NON RATIONAL Decision making by financial institutions happens because a lot ofpeople have made a ton of money which seems unjustified to the amount of value they are creating for society ina pretty short time–greed. When your senior in the company and your competitor have been choosing X over Yfor last 2-6 years and been handsomely rewarded with money , power , beautiful girlfriend/wives , Ferraris ,Lambos, Bollingers , then the question of choosing Y almost does not arise or at least is not given thethought/importance as it should be. The decision makers will automatically choose what has been working in therecent 2-6 years and which has been rewarding the other guys. The actual decision of choosing X over Y isalmost not thought about but the financial models are appropriately changed ---so that they make choosing X
  19. 19. Recent Historical Evidence effect on Decision Making1968-72 – Tech industries and 70+ p/e when Warren Buffett closed his partnership saying he cannot invest in thiskind of market. Hard to find sell recommendations on IBM , Polaroid , Kodak, Xerox, et all and all almost close to3 digit p/e . Of course the next decade S&P 500 lost almost 50% in real terms with the biggest losses from thetech industry.Latin American loan mania and Savings and Loans crisis –All bankers rushed in for these crisis and bailoutsfollowed. Lot of US banks (Citi being prominent) made lot of high yielding loans to Latin American countries andthey initially made tons of money. This recent success and money kept making the bankers to keep giving loansto these countries even when they knew that they are taking higher risk. Surely the probability of not being paidwas NOT 0. But this risk was relegated to secondary position. What mattered and was of primary importance waswhether lots of your colleagues/seniors and competitors have made lot of money by doing something. That isexactly what happened in Savings and Loans Crisis as well. The so called objective and independent mindeddecision to lend based on purely risk reward goes to Secondary importance. thLeveraged Buyouts craze during 80‘s. Even a 10 Grader could have told that if current profit is not evenenough to pay for interest how can company survive? It is going to make thousands lose the job and it didhappen. Try describing all these with any amount of probability to the investment bankers and guys making thedeals and getting their millions. Every effort to warn people would have failed to stop these kinds of madness.1999-00 Nasdaq had a p/e greater than 200. . Sane individuals should havenoted that there is at least a 5-10% chance that it may fall(Read annual reports of Buffett , Oaktree Capital ,Sequioa Funds in 1998-00 which explicitly say that this is a bubble and they completely stayed away). But pleasego and have a look at all the research recommendations from top banks and equity analysts what they werepredicting. Thousands of programmers lost the jobs because money driving the companies evaporated as thecrash was severe. Millions of people actually put their retirement savings in the hot IT stocks onrecommendations of Analysts , Banks and of course CNBC.Of course there was more than 5-10% chance of big decline in Nasdaq and other big high flying IT stocks but nomatter how badly anyone would have described the impending crisis the guys whose bonuses(read equityanalysts and bankers who make deals n IPOs) would NEVER EVER have warned or chosen to keep money in asaner company having a p/e close to earth than heaven. After all what had worked fabulously in 1997-98-99 wassure to work later as well . In any case IBG -- YBG (I‘ll be gone, you‘ll be gone). Mess – Lesser said the better it is.What I am trying to tell is that with the recent historical memory/evidence decision making under risk changescompletely from anything what any economic theory of rational decision making may imply . Choice/Decision perse becomes secondary while the recent historical evidence is given priority. Recent Historical Evidence/rewardscannot be neglected while making any theory of decision making.Institutional Imperative – Warren BuffettWarren Buffett has put in beautifully in his 1989 letters toshareholders( terming it as institutional imperative . In
  20. 20. it means that behavior of peer companies will be mindlessly imitated by others no matter how wrong they may be.This means rationality in decision making takes a backseat if the recent evidence suggest that competitors havemade money by choosing X(however dangerous or stupid that maybe) .Others will do exactly the same .―Everyone is doing it ― is the favorite explanation given. Looking collectively Stupid is fine but looking alone andmaking a mistake is equivalent to death .Here are some sample questions I have prepared which unfortunately should have been asked at those points inhistory to gauge the answers and reactions:Year 1980-82 (Background – Between 1979 and 1982 the Debt to Latin American Countries has doubled. Withthis the 8 largest Banks in US have made tons of loans to Lat Am countries. There has not been a default till date.The bankers, risk managers, deal makers have all had great time, lots of money, lots of promotions andenjoyment for the last 7-10 years. CEO of Citi Wriston has said - ―Countries don‘t go bust ―)You are a risk manager or loan approver of a Large US bank. Which option will you choose?X. Approve/Give a $1 billion loan to Mexico/Brazil/Argentina etc.Y. Not to approve the loan based on risk reward calculations.You May be best MBA, PhD, guy but if CEO says Countries don’t go Bust You AgreeCity CEO Wriston in early 80‘s said – ―Countries don‘t go bust ― and in next 1-2 year 20 countries went bust andcould not pay back the loans . Citi itself was rescued. Now if CEO says that kind of sentence what will their juniorswho actually sit and decide do --whether to give a loan to Mexico or not whatever be the probability of Mexicopaying you back . Of course the decision of actually giving/approving the loan to Mexico or any other crap countryis secondary. The juniors will use System 3 taking into account following three items: Superior Orders- The CEO (as shown above for CITI) has directed you and firm to approve the loans to Latin American Countries. Incentive – You will receive your bonus if you follow what your superiors are saying you to do . Recent Historical Evidence – For last 4-6 years loans have been performing.Now the actual term sheet of loan evaluation should be shoved on the table of the loan/risk manager.Do you need a Phd in economics to decide to approve or disprove the loan??Will you actually use your System 2 to laboriously, objectively, rationally evaluate the loan proposal and reach aconclusion which may be different than what your superior is saying??Of course NO.You may be the best Maths , Statistics, Economics, MBA , Phd guy in the world and have a title of Most rationalperson in the world but when faced with the complete picture of decision making of approving a Billion Dollar loanyou will NOT use your independent thought process. You will instead fall for using System 3 because thecircumstances for decision making are more important than the actual choosing of decision.I have given just one example but anyone can easily see that you can make 100s of examples of situations wherepeople would have rejected a conclusion had they not been under an organization , no superior order , not aincentive to choose a decision or neglect the recent historical evidence however stupid it might have been
  21. 21. Behaving the way others have behaved in the position—Zimbardo ExperimentThis may not be intuitively clear when you have read the heading but it will become once you read the amazingStanford Prison Experiment by Zimbardo . , short conclusion is this – 24 males who were deemed to be the most psychologically stable and healthy(nohistory of crime, drugs or any illegal activity) were chosen wherein half of them became prisoner and othersbecome guards in a prison like environment.The guards were given no specific training on how to be guards. Instead they were free, within limits, to dowhatever they thought was necessary to maintain law and order in the prison.Experiment created a situation in which prisoners were withdrawing and behaving in pathological ways, and inwhich some of the guards were behaving sadistically. Even the "good" guards felt helpless to intervene, and noneof the guards quit while the study was in progress. Indeed, it should be noted that no guard ever came late for hisshift, called in sick, left early, or demanded extra pay for overtime work.Second, Christina Maslach, a recent Stanford Ph.D. brought in to conduct interviews with the guards andprisoners, strongly objected when she saw our prisoners being marched on a toilet run, bags over their heads,legs chained together, hands on each others shoulders. Filled with outrage, she said, "Its terrible what you aredoing to these boys!" Out of 50 or more outsiders who had seen our prison, she was the only one who everquestioned its morality.all the prisoners were happy the experiment was over, but most of the guards were upset that the study wasterminated prematurely.After observing our simulated prison for only six days, we could understand how prisons dehumanize people,turning them into objects and instilling in them feelings of hopelessness. And as for guards, we realized howordinary people could be readily transformed from the good Dr. Jekyll to the evil Mr. Hyde .Lets try to understand how can we relate this experiment‘s conclusion (role playing ) to modern finance where itreally does seem every bank is just out there to use any means(however illegal) under the sun to take moneyaway from you and society .(If you disagree maybe you are working in a bank . Just ask how much trust yourfriends have in banks and if most say yes huge trust probably you need to change your friends).Powerful Men in Finance and their PositionsThe CEOs of the top 20 banks and to 20 investment banks are the pinnacle of what a person would want toachieve in financial industry. I do not have data but most probably these bankers move almost 80% of the moneyin the world. They hire the best and brightest from top universities and Ivy League colleges as they say creame delemme of the world.Even after knowing hundreds of fraud cases and paying billions in fines How many of the people from top banksdo you know have been convicted of doing anything illegal personally and have had to pay personal fines? Ortheir bonuses were clawed back for excessive risk taking, defrauding, cheating, and lying ?
  22. 22. Do you know any instance where a junior person refused to do a job in big bank because it was too risky orillogical or did not make sense, not in interest of clients?? Do you know any guy in all those banks combined whoresigned because banks were approving loans to No Income or No jobs people ??All answers would be NO.Do you think that almost every guy at the banks are unethical? or they Could not evaluate logically the negativeaffects which would result because of their actions ?So what happens exactly when a guy from a top notch IVY league college who has been in top percentilethroughout his life in all endeavors enters into a Investment Bank or a big Bank?What happens when a person sits at the trading desk whereby his seniors had once sat and did all kinds of thingsand are enjoying today? How does he feel? How will he act? How independent will he be from the position heoccupies?I believe that once a person enters into a big financial institution and occupies a position where no one has everbeen convicted/punished/bonus taken back/sued personally- he starts to think in a completely different way aboutthe job/work he does.Ordinary People Start to Believe in Magic of Finance and Act as others have acted earlier in their positionHe starts to behave the way the guards in Zimbardo‘s experiments behaved. Ordinary (infact brilliant guys)people who enter into banks start behaving in a way which is true to the position which they occupy i.e. dowhatever is possible (even illegal) to make money at whatever cost. Previous guys have done it . Some of themcome in Rolls Royce , some of them own ranches , yachts , super luxury mansions . Why should not you do it ?What stops you from doing ―it‖ ? Nothing. Your superiors encourage you to do it . Your peers in other companyare doing it . With all these things going on will you actually start using your System 2 and evaluate whether or is a great company of future or CDS sold by AIG should be priced high?? Or will you reject the loanproposal of the jobless widower who is a father of 4 kids ? IBG n YBG . I will be gone and You will be gone is themantra in whole of the company.You call your clients as ―muppets‖ . Goldman had to pay $500 million + to settle a suit where they defraudedclients . Do you know anyone who was personally punished/fined/lost job in Goldman for doing that deal ?? If nothen how can the fin industry be different from a typical prison where guards can literally do whatever they want todo to the prisoners and not be punished EVER.Isnt there a huge similarity to the position held by a financial industy guy and a prison guard ?When in 6 days perfectly normal people who never did crime , never were in prison , never got any training in howto behave as a prison guard start behaving in a sadistic way in a controlled experiement with paltry ($85 a daypay) how can we expect the financial industry guys to behave in a independent/logical/rational/objective mannerwhen they are sitting at a position where nobody has ever been punished/caught/held liable personally . UseSystem 2 or loss aversion or denominator neglect or certainty affect or prospect theory or bernoulli‘s utilities ???You‘re kidding right.I am sitting in a Goldman Sachs office being the trader of mortgage securities. Do I F#*&kng care or think aboutwhat will happen to the subprime bonds I have sold when house prices will start falling ?? Not a singleGoldmanite has been punished/imprisoned/held liable personally ever even when Goldman has had to pay finesin millions of dollars.Mr. Corzine the CEO of MF Global has been roaming absolutely free for last 8 months after his firm stole moneyfrom customer‘s segregated accounts . Almost $2 billion has vaporized and not a single indictment has yet
  23. 23. put on the CEO Corzine (who incidentally earlier was Goldman CEO). My bet is this on Mr. Corzine . He willNEVER EVER be convicted for cheating the customers. EVER . He will instead be employed by some other firmand will enjoy making millions of dollars again.Do you think I being in Goldman will act rationally/ethically/morally/?Or will I act the way previous guys on that position have previously acted and reaped riches of rewards possible inthis world with zero downside??LIBOR itself has been manipulated by all the big banks for so many years. Don‘t you think that there should havebeen one guy , one person who would have stood up and said NO ??You do not need a psychology degree to decipher that people start to act according to the position and situationthey are put in even though they are not inherently evil . As someone said ―Evil is knowing better but doing worse‖Guys know its wrong but they will even then do because they are acting with their System 3 .Not for a second I am telling that most people in banks are immoral or evil but lot of them do act immorallybecause they are in that position which has had a history of people doing exactly the same wrong thing whichthey are supposed to do. Cheat/defraud/do anything to make your bonus and keep your high paying job. It‘s theposition stupid!!!!!!!! Not the people.Because of the enormous power which is present in financial institutions the absolutely normal people who entertheir become exactly what the position is known for . Ruthless, heartless, ready to defraud, cheat, lobby, changerules in your favor by any means, etc becomes ingrained in anybody who sits in that position/situation.A sample questionnaire should be phrased like this :Imagine you are a subprime bond sales man in Goldman Sachs . A guy comes to you and says he wants to buyit . He is Mr. Z . Another guy comes and says he wants to bet against the subprime bonds . His name is Y. Whatwill you do if you do ?Here is what Goldman did – Make both clients happy . It chose the worst subprime bonds and sold to Mr. Z. Thenturned around gave the exact list to Mr. Y so that he can bet against and make tons of money all the while tellingMr. Z that these bonds are really good and there will not be losses as far as their models say . Abacus deal .We can debate endlessly about what is right or what is wrong in this but end of day Goldman paid $550 millionfine for doing this . Do you think Goldman guys are that stupid to NOT have know prior to dealing like this thatthey might be caught ?? Of course yes. But the position at which they sit so many times they have gonecompletely scot free that they just did it .The head guy Tourre who caused Goldman to pay $550 million in fine is still working at Goldman and must bereceiving bonuses as normal . what would you do if you sat in Mr. Tourre position tomorrow ?? Would you back out and use your System 2 ,loss aversion , denominator neglect or god knows what to decide on financial risk taking or would you do whatyour System 3 says – Go for it . The guy before you on this position and who caused $550 million fine is still withthe firm and enjoying his grand life.HSBC has recently told that it did help in money laundering for drug cartels , terrorist activities , black money ,blah blah at a huge scale . It is ready to pay fines and will do . But I guarantee there will be no PersonalConviction and nobody will go to jail for financing terrorists . From Mr.
  24. 24. ―Let‘s try out a novel idea: Banks that help drug cartels launder money and give cover to those tied to terrorismshould be put out of business. Is that really so hard for everyone to agree on?‖I can only smile and say NO we cannot agree on it . How you think that tomorrow if a MBA finance from Harvardgets recruited by HSBC and sits at a desk which was held by guys who helped launder money , make tones ofmoney , enjoy life and not punished will ACT ?? Will he use system 1 or 2 ?? Or will he short circuit his brain anduse these conditions to do what previous people have done being in that position ??Other People’s Money at Risk - OPMI have yet to see a economic/pshycological questionnaire where it starts with – ―You are managing other person‘smoney or Will you bet somebody else‘s money if odds are XYX ----------------- ―I searched Google but could not come across any decision theory which could be applied when people aremanaging other people‘s money.Will the prospect theory or loss aversion or certainty effect apply to the same extent when somebody else‘s hardearned money is at risk?My answer is NO.OPM- Other People‘s Money here will refer to investors who put money into various hedge funds and of coursethe general public which puts money into the banks . The bankers and fund managers are people who manageother people‘s money.So how do these money managers and bankers take decision under risk ? Do they take decisions just as we takewith our own hard earned cash ? Do they have similar loss aversion as we people have with respect to our ownmoney? A simple guess by anyone would say NO. There is a huge differenece in the way decision making isdone when your own cash in on the line vs when someone else‘s cash is on the line.Of course officially money managers have great incentive to make sure they don‘t lose money for the clients ,make money for them else the money manageres and bankers will lose the client or get less business from them.Unfortunately this does not represent the complete picture of the situation/condition for bankers and moneymanagers.Most hedge fund managers charge 2% of assets and around 20% of profits . There are almost 8000 hedge funds– Howard Marks on Bloomberg TV 17/72012 . When Marks started his career in early 70‘s rarest of raremanagers were able to charge this kind of exceptional incentive arrangement. Do you think there are 8000exceptional guys right now ??Infact on an average hedge funds with all their strategies and incentives are trailing even the S&P . much so for 2 plus 20.For bankers well enough said . We people don‘t have a choice . The banks before 2007-08 crisis have becomeeven larger than ever . Where will you put your money if not a bank ?How Questions on Decision Making under Risk Should be AskedSo lets get to actual framing of questions for Fund Managers which are used by decision theorists when someoneelse‘s money is at risk . Your money is safe in bank. You are going to risk someone else‘s money You have already received 2-3% off the money poured in your fund
  25. 25. You will get 20% of the profits. You will NOT have to share even a penny of loss. Suppose whole invested money goes to 0 you are NOT liable personally. If you blow up most probably everybody is also going to blow up (as has been case in history) . If you blow up individually like LTCM did don‘t worry you can still have your career later as proven by the guys who ran LTCM (they are still managing money).Now all questionnaire asked by Mr. Daniel Kahneman for developing all his theories on decision making underrisk should be put in .Pre-Conditions for Bankers(who were earlier makings tones of money using prop trading and now still managingmoney for depositors in trillions of dollars) Your money is safe in bank . You are going to risk someone else‘s money You will keep on receiving continuous monthly salary no matter what you do. You will receive great bonus if you take a huge risk and it pays off. You will NEVER receive a negative bonus or clawback no matter how badly you screw up . No matter how much you lose for the client/customer you will never be held personally liable. All profits if any will be credited for your great strategies All losses will be because of completely unforeseen events(you know those 3-5 sigma events which keep happening once every decade or so) and most probably all your competitors will also be losing same amount at same time (why do banking crisis seems to affect every single bank ) Even if you have to bend the rules a bit no problem. The bank will pay the fine for you and you will continue your job or you will land up with even bigger pay packet in other company. (Question for readers – pick out any big fine paid by any banks over years and let me know one guy who was fired or held responsible for it .)Let me explain how Loss Aversion theory becomes less important for money managers and bankers most of thetime.Another central result is that changes that make things worse (losses) loom larger than improvements or gains.The choice data imply an abrupt change of the slope of the value function at the origin. The existing evidencesuggests that the ratio of the slopes of the value function in two domains, for small or moderate gains and lossesof money, is about 2 : 1 (Tversky and Kahneman, 1991Its intuitively clear that this sentence and conclusion is true only when your own hard earned cash is on the firingline . When you yourself are going to lose your own money.Will a hedge fund manager/banker have same kind loss aversion when he is managing other people‘s money ?NOInfact it will be opposite because for fund managers/bankers their disincentive of losses is nil(very low) comparedto incentives of gains(ie risk taking). So the fund managers/bankers will almost always prefer the high riskstrategies whereby they have chance of huge gains and Zero chance of losing the money they already have.If they blow up the client’s money it is not that they will lose something which they already had. They willjust NOT get something they may have got. That is the crucial difference to understand while applying any lossaversion or indeed decision making theory to bankers/fund managers. The bankers do not lose in almost anycase (even if they blow up completely). IBG-YBG (I will be gone and you will be gone is present in financialdecision making. ) Infact if you are a top guy and managed to blow up the firm you will get multi million dollarseverance package . Go use loss aversion theory on these guys
  26. 26. From 2000 though 2008, Mozilo Countrywide CEO received total compensation of over $500 million.Read more: Try using any decision making theory on him .Stan ONeal Merril CEO got away with $160 million . If MerrillCEO Thain spent $1.22 million for decorating office I find it absolutely normal . And after a $15.3 billion during thefourth quarter alone Merrill Paid around $5.8 billion in bonuses to its executives which was higher than last yearwhen it had profits. Try using loss aversion principle on these guys.So even if you make a loss you will most probably receive bonus (and of course your salary will continue) . Henceyou will take decisions using System 3 because you are not putting your own money on the risk but managingother people‘s money.―Nobody takes the losses harder than the person most responsible. Nobody feels it more than you‖ But if thelosses are taken by someone else and you are there just to take profits then the loss aversion should be changedto profit predilection. System 3 is the answer for this. Situation/condition for taking a decision is more importantthan decision itself.What prospect theory proposes is difference in value between a gain of 100 and gain of 200 appears to begreater than difference between a gain of 1100 and 1200. Absolutely Agree.Difference between a loss of 100 and loss of 200 appears greater than difference between loss of 1100 and 1200unless larger loss is intolerable. But this loss is being talked about from your own pocket loss not the client‘smoney loss . So this loss from a banker/fund manager perspective will not feel/impact that much as it would havehad it been from your own pocket.I cannot emphasize more than this that there is complete difference in attitude and action towards risk takingwhile your own money is at risk vs OPM other people‘s money at risk .Implicit Govt/Central Bank Guarantee and Easy waiver by Paying FinesThis is true for the bankers and fund managers who become as big (or as screwed up ) as LTCM . Long TermCapital Management ( read this brilliant book where the noble prize winners completely got creamed and had it not beenbecause of some govt intervention and of course some cooperation from bankers . But by and large private fundmanagers will NOT be bailed out.So many books have been written that I don‘t want to get into those details .But here is just ―some‖ of what bailouts list. I can safely say around $1-2 trillion has been used for bailout. My Country India‘s GDP is not even $2
  27. 27. From the list you can see apart from GM n Chrysler and maybe some other small company all bailouts were forFinancial Industry . Financial Industry Privatized Profits and Socialized the losses. All bailout funds have basicallycome from taxpayer‘s money and given to Financial Industry people who manage money .So does the prospect theory or loss aversion apply completely when the risk taker knows that if he completelyblows up there is Helicopter Ben Bernanke and Tim Geithner sitting somewhere who will wire the money to hisaccount at press of a button?Is there a fear in financial decision makers that if something goes wrong they will lose something from their pocket? Of course no .With trillions of dollars shoved to save these wrong decision makers (capitalism huh .) what do you think thecurrent bankers think while choosing a risky decision ??What if you do something illegal like say manipulate LIBOR so that your traders make money ?? Simple you willnot be personally responsible , your company will pay fine and you will continue in the job/or land a more lucrative job somewhere else.Any decision making theory must incorporate these conditions where the risk of loss/jail/civil-criminal lawsuit doesnot arise no matter almost what you do or what risk you take. When you incorporate these conditions in decisionmaking theories then completely different responses will be giving by people.There are literally thousands of occasions when the big banks have paid puny fines and got away neitheradmitting nor denying guilt.For the best narrative on the punishments which SEC gives read these―One day before the GE suit, the SEC filed its $33 million settlement agreement with Bank of America in Rakoff‘scourt. The SEC‘s complaint said the company had lied to its shareholders in the proxy statement it filed seekingtheir approval to buy Merrill Lynch & Co. The proxy said Merrill had agreed not to pay year-end bonuses to itsexecutives without Bank of America‘s consent. What it didn‘t say was that Bank of America already had approvedbonuses at Merrill of as much as $5.8 billion.Who were the people who did this lying? When Rakoff asked the question, the SEC said it didn‘t know and hadconcluded it didn‘t have enough evidence to pursue claims against any individuals. For its part, Bank of Americasaid it hadn‘t lied at all and agreed to pay up just to make the SEC go away. Rakoff knew a rat when he smelledone.―Absolutely no one gets punished personally. All SEC cases go just like this. Company pays. People keep jobs,bonuses and cycle repeats. Decision making is simple. You take profits but NEVER loss.The financial industry just keeps on doing same kind of illegal things again , again and again . Keeps taking hugebonuses and NEVER be held personally liable . They can always neither admit nor deny guilt . Decision makingwhen these wonderful consequences are available will NOT follow any kind of normal theories which are presenttoday .The other small rating agency whose ratings actually predicted the crisis and saved lots of money for its clients isbeing sued .
  28. 28. How do Bankers make DecisionsP- 315How do people make the judgments and how do they assign decision weights? We start from two simpleanswers, then qualify them. Here are the oversimplified answers:People overestimate the probabilities of unlikely events.People overweight unlikely events in their decisions.------------- This is wrong when it is applied to financial industry almost completely. I am not talking about the0.01% hedge fund guys who predicted and profited from subprime but I am talking about thousands of bankersand traders who lost as much as they can in 2007-08.When applied to bankers and financial industry it should be read as follows:Bankers over or underestimate probabilities of any event based completely on the above discussed 4 factors .Arguments Against Denominator NeglectP- 321You read that ―a vaccine that protects children from a fatal disease carries a 0.001% risk of permanent disability.‖The risk appears small. Now consider another description of the same risk: ―One of 100,000 vaccinated childrenwill be permanently disabled.‖ The second statement does something to your mind that the first does not: it callsup the image of an individual child who is permanently disabled by a vaccine; the 999,999 safely vaccinatedchildren have faded into the background. As predicted by denominator neglect, low-probability events are muchmore heavily weighted when described in terms of relative frequencies (how many) than when stated in moreabstract terms of ―chances,‖ ―risk,‖ or ―probability‖ (how likely). Denominator Neglect has impact on financial industry decision makers. No matter what kind of description youcan conjure and explain in front of a banker he will completely neglect it and base his decision on Incentives,orders and recent events only. You can bring Spielberg to describe the Schindlers List type of consequence ofbanker‘s decisions and it will have NO effect at all . Spain has 25% unemployment and does anybody think thatbankers could have been persuaded not to lend to the hundreds of housing builders because consequences maybe bad (ok at least there was a very low single digit non zero probability that they may be not enough demand orprices may go down ) ----------- This does not apply to fin industry at all. No matter how badly you describe things the risk a trader/CEOis taking will completely pale when the bonus is hanging in front of him if he does take a chance. As Citi CEO put– ― we have to dance till the music is on ― . Music stopped within next 1 year (I wonder when he actually stoppeddancing)No amount of denominator or numerator neglect/accept is going to let the traders and bankers become very agileand open to risks avoidance in any of these times:· 1968-71 – Tech industries and 100+ p/e when warren buffett closed his partnership saying he cannot invest inthis kind of market. Not a single sell recommendation on IBM , Polaroid , Kodak, Xerox, et all and all almost closeto 3 digit p/e . Of course the next decade S&P 500 lost 50% in real terms