The Psychology Of Human Misjudgment – Part VI by Sanjay Bakshi,

Human Misjudgment: Bias # 9: Incentives & Incentive – Caused bias

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Most of economics can be summarized in four words: "People Respond to incentives." The rest is commentary- Steven Landsburg

Example 1: Freakonomics

Read the book (and its sequel Superfreakonomics), watch the movie.

YouTube - Freakonomics - Official Trailer [HD]

These two guys have done some wonderful work on “incentives.”

Subscribe to their old blog:

Opinion - Freakonomics Blog - NYTimes.com

And the New one

Example 2: Demand Curve

Sanjay Bakshi: The Psychology Of Human Misjudgment [Part VI]

1. Price associated with quality

2. Bribe the customer’s agent to push the product - invoking one the most post powerful psychological tendencies - the superpower of incentives

Are there “functional equivalents” of boiler room operations?

Cocaine, mutual fund units, penny stocks in boiler rooms, medical drugs, time shares, insurance - ANY product with a fat commission behind it. No matter how toxic, it WILL get pushed.

Micro-lending in Andhra Pradesh.

Yes! “Any time you create large differences in commissions where the guy gets X% for selling A, which is some mundane thing, and 10 times X for selling B, which is something toxic, you know what’s going to happen.” - Charlie Munger

You’ll get lots of B despite its toxicity.

Moreover it will get rationalized.

Man is not a rational animal, rather man is a rationalizing animal

I-C Bias is so pervasive it occurs in all professions. Lawyers make clients litigate more than its necessary.

Doctors prescribing unsuitable medication because its in their own self interest.

Read this blog post I did in 2007: Fundoo Professor: Incentive-caused Bias in the Medical Profession

Read original article from: New York Times

Auditors would overlook accounting irregularities and so on…

Client: How much is 1+1?

Auditor: How much do you want it to be?

Example 3: Credit Rating Agencies

Read this: Market Shock: AAA Rating May Be Junk - New York Times

Read this: http://www92.homepage.villanova.edu/shawn.howton/Fin%202227/articles/subprimemess.pdf

The process of converting something toxic to something pure…

This is the alchemy of ?nance.

Read this: Op-Ed Columnist - All Fall Down - NYTimes.com

Charlie Munger:

"Whose bread i eat, his song i sing"

"Fear professional advice especially when it is good for the advisor."

"Double check, disbelieve, or replace much of what you’re told, to the degree that seems appropriate after objective thought"

I love this quote...

“Of the many advances in the long history of commerce, the advent of sausage stands out as one of the greatest...

“The idea of taking something which, in pure form, would be repellent to potential customers, and by thorough grinding, mixing, reshaping and adulterating, creating an entirely new entity that could be marketed free from the taint of its original ingredients, marked a milestone in the annals of business thought. Sausage making is the prototype for an entire class of merchandising technique that has become particularly common in modern ?nance. The ?nancial marketer who uses commingling as an approach is responding to the same general conditions that drive the sausage stuffer: an abundance of lower grade ingredients along with hungry and credulous public.” – Michael Aronstein

Be Wary of Financial Innovation…

The guys who do it keep on re-inventing the wheel and hoodwink you into believing that what they are doing “this time, its different.”

Galbraith once wrote: “All ?nancial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets … All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.”

He was right as you’ll discover when you read “The Great Crash 1929

Munger advices you to never ask the barber if you need a haircut.

Example 4: Tobacco

Scene from “Thank you for smoking”

YouTube - Thank You For Smoking Movie (1/9)

This is a great movie which highlights a man who is a lobbyist for the tobacco industry, does a brilliant job, and faces no cognitive dissonance because he is doing it “for the money.”

However everything changes in the last scene...

See full slides below.