Saturday, January 31, 2009

Behavorial Accounting? Executive Overconfidence and the Slippery Slope to Fraud by Catherine Schrand, Sarah Zechman

SSRN-Executive Overconfidence and the Slippery Slope to Fraud by Catherine Schrand, Sarah Zechman: Interesting paper.


First from the abstract:
"...executive overconfidence increases the likelihood that a firm commits financial reporting fraud. A manager that faces an earnings shortfall is more likely to manage earnings to overcome it if he believes the shortfall is temporary and, hence, the earnings management will be a one-off event that likely will go undetected....Overconfident managers with unrealistic beliefs about future performance are more likely to find themselves in this situation.....Our analysis that uses firm-level proxies for overconfidence suggests that there are two types of frauds: Those associated with moderate levels of overconfidence, perpetrated by executives who ex post fall down the slippery slope, and those perpetrated by executives with extreme overconfidence that commit fraud for opportunistic reasons ex ante. Analysis of individual executives supports the notion that there are two types of overconfident executives that engage in fraud. Those with opportunistic motives are more likely to....earn more total and have a higher percent of variable cash compensation, and are less likely to have accounting experience. Finally, we document that a matched sample of non-fraud firms do not have stronger governance mechanisms that prevent fraud. This result mitigates [lessens] the possibility that it is weak governance rather than executive overconfidence that is a significant determinant of fraud.

Many interesting things to consider here!
  • The logic that over confident managers are more likely to commit fraud makes perfect intuitive sense and while some might have some reservations with the attempt to determine what industries attract overconfident managers (for instance seemingly these industries have higher variances and thus at times are overvalued and fraud could be partially explained by this (see Jensen 2005,2008)), the notion definitely makes sense.
  • It was interesting (and not very surprising) to see that those who had more to gain (more variable pay) or more to lose (founding families) were more likely to commit fraud, but disappointing to see that common governance measures did not reduce the fraud risk. Not sure what to make of that.
Good stuff!


Cite:
Schrand, Catherine M. and Zechman, Sarah L. C.,Executive Overconfidence and the Slippery Slope to Fraud(December 30, 2008). AAA 2009 Financial Accounting and Reporting Section (FARS) Paper; Chicago Booth School of Business Research Paper No. 08-25. Available at SSRN.

Friday, January 30, 2009

The Bailout Game | Home

The Bailout Game | Home-- Ok, forget academic finance, this is good and funny! You can decide whether to bail out the various players or let them fail. Takes a second to load but is really well done!

Thanks to Charlie (a former student) for sending this along to me.

Spotlight on Bonuses

It seems like everyone's attention has turned to pay and bonuses at Financial Institutions, so I will at least temporarily join the crowd.

To set the stage, this is just a sampling of the 3,745 news items (according to Google) today alone that dealt with Wall Street bonuses

From What Red Ink? Wall Street Paid Fat Bonuses-NY Times.

"Despite crippling losses, multibillion-dollar bailouts and the passing of some of the most prominent names in the business, employees at financial companies in New York, the now-diminished world capital of capital, collected an estimated $18.4 billion in bonuses for the year.

That was the sixth-largest haul on record, according to a report released Wednesday by the New York State comptroller."

From CBS News:



Obama Pressures Wall Street Over Bonuses - NYTimes.com:
"President Obama branded Wall Street bankers “shameful” on Thursday for giving themselves nearly $20 billion in bonuses as the economy was deteriorating and the government was spending billions to bail out some of the nation’s most prominent financial institutions...."there will be time for them to get bonuses....Now’s not that time.”
I agree with most of the articles and the President but not for the fairness reasons (although as a signal to customers and employees accepting any bonus seems a horrible move) but rather because what a bonus is intended to do.

Bonuses are meant as rewards used to create the proper incentives. Bonuses that are paid regardless of performance do not do that. And yes I realize that bonuses are way down, but given their performance, they still seem too high.

If you take a second and examine compensation, there are two key things to consider: the level of pay (how much you pay people) and the form of pay (Salary, Bonus, market-based pay etc.). Each is important, but the form much more so.

Level of pay is what attracts and keeps employees (and yes even managers). In the words of Keven Murphy when I took his class, it is what "gets them in the door and what keeps them. Form of pay (and re-evaluations of the level of pay) is what creates incentives and helps to motivate people to do what we want them to do.

Don't think so? Consider this example directly from my class. Suppose you are hired as CEO of a firm and paid a straight salary of $2 million a year. You are told that the pay will never change so long as your firm does not go out of business and you can not be fired. How would you behave? Consider the many agency costs that may arise. Risk taking would likely be scaled way back, debts reduced, dividends and capital expenditures lowered since your main goal is to keep the firm in business so you get your $2 million annuity.

Bonuses and market-based pay are, at least in theory, designed to motivate the employee to do what is in the firm's (and more specifically the shareholders') best interest. For instance, stock options that increase in value with increasing volatility, are a means of making managers less risk averse. Bonuses are similar but more often based on non market factors (either accounting-based or performance based).

Which gets us back to the question of paying Wall Street executives bonuses. If the form of pay is to serve as a proper motivator (that is to motivate them to do what we want), something has to be at risk (Again go back to the example, if I say you get a $2 million bonus no matter how well you do, does it motivate you or is it just another word for salary?).

By any standard, most financial institutions have had a horrible year. To reward managers (which is essentially saying "Good job") is wrong. Indeed, a strong case may be made that the reason why bonuses have been so high over the past few years is not that the firms were doing so well, but that they appeared to be doing so well and the outcome of many of the investments had not yet been determined. Thus some ex-post settlement (IF I remember correctly it was Jensen and Meckling in 1976 who suggested this) whereby the executives give back past bonuses (and not just this year's) is really what should happen.

Now of course it is not going to. There is a movement afoot to get some of this year's bonuses back at firms who got government bailouts but even this faces very long odds.

While it may be a disappointment (in the spirit of no matter how many times Charlie Brown goes to kick the football, I always hope that Lucy will come around this time and do the right thing and let him kick and I am disappointed when Lucy pulls it away), it really should not be a surprise to anyone that managers will largely get their bonuses even if the bonuses are smaller than in the past (remember they probably should not have gotten the past ones at all if the true value of their investments were known then).

As Garvey and Mibourn (2003) showed managers tend to get rewarded when things go right (good luck?) and yet are not penalized when things go wrong (bad luck?). I somehow doubt that this time around will be any different Charlie Brown will still end up on his back and managers will still look out for themselves and not shareholders.

Financial Rounds: Biases in Implied Volatilities

I will TRY to get to this later, but it is so important (yeah I am biased--I like implied volatilities) that I did not want to take any chances of getting busy and not getting to it AND besides it is a good opportunity to suggest new readers take a look at Financial Rounds. It is one of my favorites and written by another FinanceProfessor (who goes by the Unknown professor).

Financial Rounds: Biases in Implied Volatilities

"In their paper "Implied and Realized Volatility in the Cross-Section of Equity Options" Manuel Ammann, David Skovmand and Michael Verhofen examine whether implied volatilites differ systematically from realized vlatilities, and whether those differences are related to firm risk (beta) size (market cap),growth opportunities (market/book), and momentum. Here's the abstract:

Using a complete sample of US equity options, we analyze patterns of implied volatility in the cross-section of equity options with respect to stock characteristics. We find that high-beta stocks, small stocks, stocks with a low-market-to-book ratio, and non-momentum stocks trade at higher implied volatilities after controlling for historical volatility. We find evidence that implied volatility overestimates realized volatility for low-beta stocks, small caps, low-market-to-book stocks, and stocks with no momentum and vice versa. However, we cannot reject the null hypothesis that implied volatility is an unbiased predictor of realized volatility in the cross section."

Thursday, January 29, 2009

Google Trends: unemployment


With thousands of jobs being lost daily, thought it might be interesting to look at the number of searches for unemployment being done on Google. Not surprisingly the searches are way up (about 3 times as high as a few years ago).

Google Trends: unemployment: "Scale is based on the average traffic of unemployment from United States"

Wednesday, January 28, 2009

Commentary: How to rescue the bank bailout - CNN.com

Joseph Stiglitz has a thoughtful piece on CNN.com. While I disagree with what appears to be a call for the nationalization of more banks, I do agree that rewarding upside without some real downside risk will only yield more risky behavior which will hurt the economy and lead to future blow-ups. My solution I guess would be to both allow temporary nationalizations (but with a hard fast exit date of no more than five years where the bank is either sold or closed) but also bite the bullet and let some banks fail now. Sure it is painful. Sure some will lose jobs, but what is the alternative?

Some look-ins that might help explain why there is no simple quick fix:

Commentary: How to rescue the bank bailout - CNN.com:
"For a while, there was hope that simply lowering interest rates enough, flooding the economy with money, would suffice; but three quarters of a century ago, Keynes explained why, in a downturn such as this, monetary policy is likely to be ineffective. It is like pushing on a string."
Then:
"...came the idea of equity injection, without strings, so that as we poured money into the banks, they poured out money, to their executives in the form of bonuses, to their shareholders in the form of dividends.

Some of what they had left over they used to buy other banks -- to pursue strategic goals for which they could not have found private finance. The last thing in their mind was to restart lending."

And his version of "Debt makes good times great, bad times horrible" and realization the problem is REALLY big:
"Leverage, or borrowing, gives big returns when things are going well, but when things turn sour, it is a recipe for disaster. It was not unusual for investment banks to 'leverage' themselves by borrowing amounts equal to 25 or 30 times their equity.

At 'just' 25 to 1 leverage, a 4 percent fall in the price of assets wipes out a bank's net worth -- and we have seen far more precipitous falls in asset prices. Putting another $20 billion in a bank with $2 trillion of assets will be wiped out with just a 1 percent fall in asset prices.... So they have come up with another strategy: We'll 'insure' the banks, i.e., take the downside risk off of them.

The problem is similar to that confronting the original 'cash for trash' initiative: How do we determine the right price for the insurance?"
Why aren't banks lending?

"But even were we to do all this -- with uncertain risks to our future national debt -- there is still no assurance of a resumption of lending....risks are high in a recession. Having been burned once, many bankers are staying away from the fire...Many a bank may decide that the better strategy is a conservative one: Hoard one's cash, wait until things settle down, hope that you are among the few surviving banks and then start lending. Of course, if all the banks reason so, the recession will be longer and deeper than it otherwise would be."

DAVOS 2009 - DealBook Blog - NYTimes.com

Davos always creates good news items, interviews, and even class discussions. Keep on eye on the NY Times blog from the festivities.

DAVOS 2009 - DealBook Blog - NYTimes.com:
"A team of reporters and editors from The New York Times and The International Herald Tribune will be in Davos, Switzerland, reporting on World Economic Forum Annual Meeting 2009 from Jan. 28 to Feb. 1. The conference brings together world leaders from politics, business, religion, media and philanthropy. We will be providing updates throughout the day with news and analysis."

SSRN-Moral Hazard in Leasing Contracts: Evidence from the New York City Taxi Industry by Henry Schneider

Great for class! Interesting, memorable, and on a topic which students often find boring and forgetful.

Leasing is an important, but understudied method of financing a wide range of assets. Unlike owning an asset where the owner of the asset is also the user of the asset, in a lease (and also in a rental agreement), the asset is used by one party (lessee) and only reverts to the lessor after the contract expires. Thus, it can lead to behaviors that are different than if the owner was also using the asset.

These differing behaviors are generally called a moral hazard problem and can help explain why many treat a rental car differently than their own vehicle.

Henry Schneider takes this idea one step (uh, one mile may be more appropriate) and examines the differences between taxi cab driver behavior when the taxi is leased vs when it is not.

the main finding: Even after controlling for endogeniety problems (that is self selection where safer drivers might be more apt to own), leasing does seem to lessen the maintenance and care of the vehicles and lead to more accidents.

The paper: SSRN-Moral Hazard in Leasing Contracts: Evidence from the New York City Taxi Industry by Henry Schneider:
"...evidence about the leasing moral hazard by examining the New York City taxi industry, which is split between taxis operated exclusively by lessees and taxis with owner-drivers. Lessees have significantly worse driving outcomes than owner drivers:

In 2005, long-term lessees experienced 62 per cent more accidents and 64 percent
more driving violations per mile than owner-drivers, and operated taxis that failed vehicle
emissions and safety inspections at a 67 percent higher rate. Moral hazard is an obvious candidate to explain these differences...contracting over driving outcomes instead of actions also faces obstacles since taxis are typically operated by multiple drivers, which prevents some driving outcomes (e.g., vehicle mechanical failures) from being matched to individual drivers....",
On the endogeneity issue:
"...controlling for driver and vehicle characteristics is not straightforward: As
with most empirical work in contract theory...address this challenge in three ways. First, I
estimate the difference in outcomes between lessees and owner-drivers conditioning on a
rich set of observed driver characteristics. Second, I conduct an instrumental variables
analysis to address the possibility of unobserved driving risk that is correlated with leasing
choice, instrumenting for leasing choice with community norms for taxi-ownership. Third,
I compare the before and after outcomes of the 1,130 drivers who switched from leasing
to owning during the sample period....All of these approaches yield qualitatively similar results..."
and finally:
"After controlling for vehicle usage and driver characteristics, I estimate that moral
hazard explains 34 percent of lessees’ violations, 18 percent of their accidents, and 30
percent of leased taxis’ vehicle inspection failures."

Cite: Schneider, Henry S.,Moral Hazard in Leasing Contracts: Evidence from the New York City Taxi Industry(November 2008). Johnson School Research Paper Series No. #03-09. Available at SSRN: http://ssrn.com/abstract=1146648

good stuff!!

Monday, January 26, 2009

RGE - Everything You Wanted to Know about Credit Default Swaps--but Were Never Told

Ok, this is a clear case of substance over form. Great material, but challenging to compress in the few minutes (ok, so negative minutes-but I am always late, so?? ) I have before I have to go to a meeting. BUT it is very good and I definitely recommend looking over it. I will try to summarize later. Two look-ins now


RGE - Everything You Wanted to Know about Credit Default Swaps--but Were Never Told:

"...if CDSs are not responsible for the financial crisis or the need to rescue financial companies, why are they so distrusted? Some observers may simply be drawing a causal connection between the current financial crisis and something new in the financial firmament that they do not fully understand. Misleading references to the large "notional amount" of CDSs outstanding have not helped. This Outlook will outline how CDSs work and explain their value both as risk management devices and market-based sources of credit assessments. It will then review the main complaints about CDSs and explain that most of them are grossly overblown or simply wrong. Improvements can certainly be made in the CDS market, but the current war on this valuable financial innovation makes no sense."
and later
"In light of the consistent failure of traditional regulation, a sophisticated and intelligent regulatory process should now foster risk-management innovations that have been developed by the private sector, especially the derivative instruments that have greater potential to control risk than government oversight. CDSs are one of these instruments, but not the only one."

Peter Schiff's Clients Down In 2008

Remember Peter Schiff? How he called the market collapse? If you don't, here is the link to his video that was spotlighted last fall.

Well, it appears that while he seemingly called that correctly, he has not been as good at making money on the call.

From Clusterstock: Peter Schiff's Clients Down In 2008:
".... several clients who claim losses of 40%-70% after investing with EuroPacificCapital. How could this be? Hasn't Schiff been bearish during a horrible year for US equities? Yes, but that negative on US equaties was just a part of his overall strategy"

Which yet again shows how difficult it is to beat the market on a risk adjusted basis.

Saturday, January 24, 2009

SFA 2009 Annual Meetings

What are you doing this coming November? How about going to the Southern Finance Association Annual meetings? The deadline for paper submission is coming up.

SFA 2009 Annual Meetings: "Southern Finance Association Annual Meetings November 18 - 21, 2009"

"Interested in presenting a research manuscript, or organizing a special session, a panel discussion or a tutorial?
Please complete and submit the Paper Submission or Special Session proposal form at the Southern Finance Association website. The deadline for manuscript submissions, as well as topics for special sessions, panel discussion, and tutorials, is Monday, March 2nd, 2009. Only electronic submissions of papers (in Adobe Acrobat form) will be considered.

Interested in serving as a discussant or session chairperson?
Please complete the Participation as Chair or Discussant form available on the Southern Finance Association website. The deadline for submitting the meeting participation information is Monday, March 2nd, 2009."

FinanceProfessor.com Podcast

FinanceProfessor.com Podcast-

Let's see if this goes better this time around. I tried it a few years ago and very few students used it, but it seems like it should at least help those who miss class. So I will begin posting MBA 610 lectures again this semester. The notes (always a work in progress) for the class are largely here.

Friday, January 23, 2009

The role of Speculation on oil prices

60 Minutes recently did a piece on the impact of speculators on oil prices that is worth some attention.

Did Speculation Fuel Oil Price Swings?, 60 Minutes: Speculation Affected Oil Price Swings More Than Supply And Demand - CBS News: "'Approximately 60 to 70 percent of the oil contracts in the futures markets are now held by speculative entities. Not by companies that need oil, not by the airlines, not by the oil companies. But by investors that...don't actually take delivery of the oil."

Much later:
"Gilligan said. "I tease people sometimes that, you know, people say, 'Well, who's the largest oil company in America?' And they'll always say, 'Well, Exxon Mobil or Chevron, or BP.' But I'll say, 'No. Morgan Stanley.'"

Morgan Stanley isn't an oil company in the traditional sense of the word - it doesn't own or control oil wells or refineries, or gas stations. But according to documents filed with the Securities and Exchange Commission, Morgan Stanley is a significant player in the wholesale market through various entities controlled by the corporation.

It not only buys and sells the physical product through subsidiaries and companies that it controls, Morgan Stanley has the capacity to store and hold 20 million barrels. For example, some storage tanks in New Haven, Conn. hold Morgan Stanley heating oil bound for homes in New England, where it controls nearly 15 percent of the market. "




Interesting. I should warn you that the video is not ground breaking (for as anyone knows speculation obviously played a role in price swings), but worth including as it shows how far investment banking has gone from traditional investment banking and it has some good insights in the market for oil.

Thursday, January 22, 2009

Why Economics Is Important! (Mises & Keynes, Think So!) | Simoleon Sense

SimoleonSense has the following great piece.

Why Economics Is Important! (Mises & Keynes, Think So!) | Simoleon Sense:
"Economics must not be relegated to classrooms and statistical offices and must not be left to esoteric circles. It is the philosophy of human life and action and concerns everybody and everything. It is the pith of civilization and of man’s human existence…”

“In such vital matters blind reliance upon “experts” and uncritical acceptance of popular catchwords and prejudices is tantamount to the abandonment of self-determination and to yielding to other people’s domination.”

“Economics deals with society’s fundamental problems; it concerns everyone and belongs to all. It is the main and proper study of every citizen.”"

I can not tell you at how many family dinners and group runs that the idea that economics should be a required class for all students has come up, but it is in the hundreds. Well said!

Holy Agency Costs Bat Man

Wow. Talk about your agency cost problems.

$1.2 Million Spent On John Thain's Office:
"Amidst everything else going on at Bank of America (BAC) and its boneheaded decision to buy dying Merrill Lynch, Gasparino reports, for the Daily Beast, that John Thain had a ridiculous amount spent on his own perks, including a redecorating of his office.

According to documents reviewed by The Daily Beast, Thain spent $1.22 million of company money to refurbish his office at Merrill Lynch headquarters in lower Manhattan. The biggest piece of the spending spree: $800,000 to hire famed celebrity designer Michael Smith, who is currently redesigning the White House for the Obama family for just $100,000.

The other big ticket items Thain purchased include: $87,000 for an area rug in Thain's conference room and another area rug for $44,000;"
The list goes on, but enough is enough....

Which surely reminds others of the problems at Tyco about 6 years ago. Don't remember? Here are some of what I wrote about it at the time in the old FinanceProfessor Newsletter in August 2002:
"...the ex-CEO of Tyco has pulled the wool over investors’ eyes more than anyone knew. It is reported that he received approximately $135 million from the firm that was above and beyond any reported pay. How? $18 million for a plush NYC apartment plus over 2 million to furnish it (where would one find a $6000 shower curtain?!?),
forgiven loans, the payment of the taxes on the forgiven loans, foreign
trips, and even birthday party for his wife that featured a concert by
Jimmy “don’t call me Warren” Buffett. (It seems he was a real world
version of Brewster from Brewster’s Millions!)
and then again in September 2002.

"Tyco: It seems Tyco had more problems than originally thought. Not only did Dennis Kozlowski get many unreported perks from the firm, now reports indicate that others at the firm also partook in the excess. Some had loans forgiven and some rather extravagant (and unreported at the time) perks including $15,000 for dog umbrellas and $2900 for hangers! (Can you imagine the size of the closet?!) One theory behind this lavish spending is that Kozlowski was trying to “buy off” those who knew what he was doing. All told over $170 million may have been taken from the firm. "
In case you were wondering, Kozlowski did end up in jail.

See his 60 Minutes inteview from 2007. It is definitely worth watching and very good. I had never seen it until now. (sorry I can not embed it. Click here.)

A much shorter (and not as good IMO) version with Katie Curic is here:

Lesson One: What Really Lies Behind the Financial Crisis? - Knowledge@Wharton

It is a simple rule, but like many other rules, there is a great temptation to break it. If you are a financial intermediary you should not take positions (i.e. buy and hold), but merely work as a conduit. You make your profits on transactions not market moves. A mental literature review of this idea goes back at least to Hasbrouck and Sofianos (1993) and Madhaven and Sofianos (1998). (True they were writing about specialist firms but the point is the same.

Why is it worth noting today? Because as Jeremy Siegel noted recently not abiding by the "rule" got many financial giants into a whole heap of trouble.

From Knowledge@Wharton:

Lesson One: What Really Lies Behind the Financial Crisis? - Knowledge@Wharton:
"According to Siegel: Financial firms bought, held and insured large quantities of risky, mortgage-related assets on borrowed money. The irony is that these financial giants had little need to hold these securities; they were already making enormous profits simply from creating, bundling and selling them. 'During dot-com IPOs of the early 1990s, the firms that underwrote the stock offerings did not hold on to those stocks,' Siegel says. 'They flipped them. But in the case of mortgage-backed securities, the financial firms decided these were good assets to hold. That was their fatal flaw.'"


The article, based on a presentation Siegel made as part of Wharton's series on the finacial crisis, went on to include these points:

CEOs needed to understand the risks their firms were taking:
"Siegel pointed to two interlocking issues: One is a massive failure, not only by traders, but by CEOs of financial firms, their risk management specialists and the major rating agencies to recognize that an unprecedented housing-price bubble began building after 2000....They believed that as long as home prices kept rising, the underlying value of the real estate would provide a hedge against the risk of such defaults. They failed to realize that this reasoning was based on the assumption that home prices would go in just one direction -- up. In fact, these assets became enormously risky once the housing bubble burst and home prices began their inevitable decline. Siegel also argued that ultimately, the buck stops with corporate CEOs who didn't ask hard enough questions about the risks posed by mortgage-backed assets."
He also had criticism for The Fed (and particularly Greenspan)
""[Greenspan was] the greatest central banker in history -- he had access to every piece of data," Siegel said. "He could have looked at the balance sheets of Morgan Stanley or Citigroup and said, 'Oh my God -- they didn't neutralize their risk.'"'

Tuesday, January 20, 2009

Back to class and back to blogging

Well it is time to restart our engines.

It has been a while. Texas went great. Really got a great deal done. I would encourage others to go volunteer in the area. It may set your pocket book back a bit, but well worth the price. You will help others.

Ok, so fast recap. When classes ended the Dow was at about 8500 it rose to a bit over 9,000 at the start of the year and is now down to about 8200 (down a bit more than 3% since our last class).

In other news, while the speed and surprise of financial difficulties may have abated, financial firms are not out of the woods yet. Recently the Royal Bank of Scotland announced major losses and the need for a cash infusion from the Bank of England. (interestingly RBS was a frequently studied case study in my finance classes in past years for the agressive takeovers.).

As soon as I get my last syllabus in, we can get back to regular blogging. See you soon!

Saturday, January 10, 2009

One Fund, 10 Years, No Annual Losses | Mutual Funds Update | Financial Articles & Investing News | TheStreet.com

Interesting trivia:

One Fund, 10 Years, No Annual Losses | Mutual Funds Update | Financial Articles & Investing News | TheStreet.com:
"....TheStreet.com Ratings team combed its database of open-end equity and hybrid mutual funds to search for such a performer. Astoundingly, we uncovered a single fund that has not suffered an annual loss over the most recent 10 years.

The GMO Alpha Only Fund III (GGHEX Quote - Cramer on GGHEX - Stock Picks) fulfilled its purpose of hedging against losses while successfully investing on the 'long' side of the market to become the only equity or hybrid fund to pass the 10-calendar-years-with-no-annual-losses test for the decade ended Dec. 31, 2008."

Friday, January 09, 2009

Where in the world are you?

hey folks, I am fine. Thanks for the concern.

It is just that I am working with BonaResponds in Bridge City for about 2 weeks. You can read what we are doing on our BonaResponds blog.

Friday, January 02, 2009

Why We Take Risks — It's the Dopamine - TIME

We know that most investors are risk averse, but in spite of that, many of us take risks that rationally may not make sense. In class we have generally explained this via a catch-all "Its fun" and people maximize utility not a risk adjusted return.

From science we now have a better grasp on the "it's fun".

From Time: Why We Take Risks — It's the Dopamine - TIME:
"A new study by researchers at Vanderbilt University in Nashville and Albert Einstein College of Medicine in New York City suggests a biological explanation for why certain people tend to live life on the edge — it involves the neurotransmitter dopamine, the brain's feel-good chemical. (See the Year in Health, from A to Z.)

Dopamine is responsible for making us feel satisfied after a filling meal, happy when our favorite football team wins ....It's also responsible for the high we feel when we do something daring,...skydiving out of a plane. In the risk taker's brain, researchers report in the Journal of Neuroscience, there appear to be fewer dopamine-inhibiting receptors — meaning that daredevils' brains are more saturated with the chemical, predisposing them to keep taking risks and chasing the next high.....

The findings support Zald's theory that people who take risks get an unusually big hit of dopamine each time they have a novel experience, because their brains are not able to inhibit the neurotransmitter adequately. That blast makes them feel good, so they keep returning for the rush from similarly risky or new behaviors, just like the addict seeking the next high...."It's a piece of the puzzle to understanding why we like novelty, and why we get addicted to substances ... Dopamine is an important piece of reward."
So, there are risk lovers out there.

Putting Bernie Madoff On The Couch - TIME

While it is not a finance article per se, it is interesting and relevant for any class discussion on the Madoff case specifically and many frauds more generally. Especially since it does not fit normal (i.e. rational) economic models.

Putting Bernie Madoff On The Couch - TIME:
"No matter how grand your ill-gotten Bentley or your cooked-books villa, they have to be hard to enjoy when you know that at any moment the jig could be up....

A Ponzi scheme — as anyone smart enough to engineer one knows — is a plan that is uniquely without an exit strategy. It requires a constant infusion of new investors to pay off a growing body of existing ones, and ultimately it becomes impossible to find enough suckers. When that happens, the scam collapses. Sure, you could always flee the country before the roof caves in, but many scammers don't and Madoff famously didn't. The reason lies in the personality — or, more accurately, the personality disorder — that drives them to such frauds in the first place.

Forensic psychologists studying Madoff-type minds start with the usual menu of personality disorders, particularly narcissism. "These people get real enjoyment from doing what they do," says forensic psychologist Michele Galietta of John Jay College of Criminal Justice in New York City. "They feel good pulling the wool over other people's eyes."