The Psy-Fi Blog

Happy People Make Terrible Traders

noreply@blogger.com (timarr) — Thu, 24 May 2012 06:14:00 +0000

Happiness causes over-optimism which causes over-trading. Repeat until crash occurs.

Optimistic Fools

People who are happy are more confident and expect to make more money by trading, and anticipate taking lower risks in doing so. This result ought to be enough to depress most people, but most people are optimistic and don’t depress easily. This is especially true if they make money on their random trades, because that makes them happier, more optimistic and more prone to trading.

Even better, over-optimistic people are more socially popular and therefore more likely to be imitated. Whether any of this will really make anyone happier is doubtful, but we can but hope. It certainly won’t make for better investors.

Egos at Large

The research that investors tend to be overconfident is pretty strong. We covered a summary of the evidence in Overconfidence and Over Optimism: investors overtrade and the amount they overtrade is related to their degree of overconfidence. And generally the more they trade the less money they make.

It’s possible this is a problem of self-selection, where it’s mainly over-optimistic people who over-trade. However, this isn’t just a problem in investment. Humans seem, by and large, to be habitually overconfident on most positive traits and, according to this research by Williams and Gilovich, genuinely believe their flattering self-assessments. This, as the researchers suggest, seems to be related to the bias blind spot we looked at in Bamboozled by Your Bias Blind Spot.

Part of this seems to be caused by a basic problem of reference group neglect or egocentrism. People don’t take into account the competition when they’re asked to compete, but simply consider their own abilities at the task in hand. If the task is simple, they feel confident and ignore the fact that it’s easy for everyone else as well. And vice versa when the task is hard. This is the hard-easy bias we touched on in Parsimonious, Big Picture Behavioral Bias.

Leaping Small Rhinos

So it may be that people are mistaking the fact that trading is easy – it’s just a matter of pressing a few buttons – for the point that consistently making a decent return is hard. After all, stockmarket investing is a fiercely competitive environment – are you really better at it than the majority of other people out there?

All this leads to the awkward question of why we’re overconfident. Generally you would think that being overconfident would lead people into doing stupidly rash things, which might be OK in our health and safety conscious world but would probably have been quite dangerous when swinging about in the primeval jungle without a safety net, safety harness, hard hat, all-over body armor and insurance policy.

One possible explanation for this is the superpower of selection for social skills outweighing the possible downside of being eaten alive. Roughly it seems that a human who could negotiate the minefield of social relationships had an evolutionary advantage over one that could wrestle giant pythons, leap canyons and out bench-press small rhinos.

Socially Confident

At least, that’s the hypothesis investigated by Jessica Kennedy, Cameron Anderson and Don Moore in Social Reactions to Overconfidence. Do the Costs of Overconfidence Outweigh the Benefits? The social argument is that overconfidence provides social benefits, such as higher status in groups. One counter to this might be that if someone’s overconfidence was revealed as just that – an self-perpetuating illusion – then this would cause a negative reaction within the social group.

Well, in fact, when the researchers investigated this, the findings suggest that overconfident people are rewarded by a higher social status, and that this isn’t affected by revealing that they’re just as useless as everyone else. We’re just attracted to irrationally confident people. This is a good social reason to explain why we’re inherently overoptimistic – we gain status and influence by presenting such a face to the world.

Happy People, Terrible Investors

There may, however, be another underlying reason for our innate overoptimism – it may be related to feeling happy. When Guy Kaplanski and colleagues looked at the relationship between happiness and investing they found:

“The happier the subject the more optimistic she is with regard to the stock market. Specifically, we find that the better the general mood of the individual, the better the perceived weather, and the better the results of the individual’s favorite soccer team in the days close to the questionnaire completion date, the higher the predicted expected return in the U.S. market as well as in the domestic Dutch stock market.”

Basically happy people expected higher returns and anticipated that they’d get this while taking lower risks. It’s well documented that seasonal effects have an impact on investors – a phenomena we looked at in Rock On, January Effect – but it’s an interesting twist that it’s related to optimism and thence to emotional cues associated with happiness. Of course, if you have to be optimistic to invest then you’ll likely invest more when you’re happy. Cue a vision of happy smiling investors throwing their money at the latest market upturn.

Excited Bubbles

The idea that emotions are related to market booms is one that’s been around a while, but it’s now been specifically investigated in Bubbling With Excitement, by Shengle Lin, Terrance Odean and Eduardo Andrade. They hypothesised that if emotions are linked to investing then they might be able to induce overtrading by putting respondents in a good mood. Their results support the theory:

“We document, in an experimental setting, that magnitude and amplitude of bubbles is greater when prior to trading traders experience high intensity, positive emotions than when they experience low intensity, neutral emotions, or high intensity, negative emotions. Thus rapidly rising prices may trigger the very emotions that lead to larger asset pricing bubbles.”

The twist in the tail is that positive emotions induce more buying, which tends to raise prices, which induces positive emotions, which induces more buying. Squaring the overall circle leads to a suggestion that happy people are more confident about their judgements and are more likely to trade as a result. Add to this our social preference for people who are habitually overconfident, often for no good reason, and our innate herding instincts (see: Herd of Investors) and you can easily end up in a situation of mass delusional positive feedback: aka a stock market bubble.

Perspiration, Not Inspiration

Knowing all this and doing something about it are two different things. Trading because we’re overconfident because we’re happy and feeling happy because trades are successful are primarily unconscious behaviors, as is our tendency to attribute positive qualities to over-confident people. Nor can we turn-off the emotional tap, emotions are designed to keep us safe and to allow us to interact successfully with other people, they’re not things we can switch on and off at will.

The general trick, as most highly successful investors report, is to follow an investment process which reduces the emotional impact of personal judgements as much as possible. By reducing the scope for emotional error we increase our chances of being successful. Learning to distrust other peoples’ opinions, no matter how confidently parlayed, when they’re not evidence based would help as well. Best trick, though, is to fixate on the idea that investing is bloody hard and most people are better at it than we are: less confidence, more effort. Successful investing is mainly perspiration, not inspiration.

Overconfidence and Over Optimism
Bamboozled by Your Bias Blind Spot
Big Picture, Parsimonious Behavioral Bias
Rock On, January Effect
Herd of Investors
Get An Emotional Margin Of Safety
Gambling, From Iowa To Soochow
The Lottery Of Stockpicking
Gross National Happiness
Money Can't Buy Happiness
Depressed Investors Don't Need Feedback

Parsimonious, Big Picture Behavioral Bias

noreply@blogger.com (timarr) — Tue, 22 May 2012 06:00:00 +0000

107 Ways of Being Wrong

As we’ve seen in The Big List of Behavioral Biases, there are 101 (well, 107 at the time of writing) ways in which people exhibit irrational biases. The basic idea, that we’re affected by these biases in predictable ways, is now well accepted. The problem is that there are simply too many biases for this to be the be-all and end-all of the explanation of market irrationality.

So while the basic concepts of behavioral finance are understood, in the sense that irrationality is a driving force of market misbehavior, the underlying mechanisms by which they operate are not. There's not much point in claiming that these behaviors are predictable if you can't use them to predict anything, So what's the big picture of behavioral bias: how does it all fit together?

Cottage Industry Economics

Although finding some new bias, putting a name to it and publishing has become a cottage industry for economics and psychology researchers the underlying problem remains that there’s no unifying theory of how everything fits together. This isn’t a minor problem, either, because unless we possess that theory we can’t use behavioral finance to do anything useful in the way of prediction. This is one of the criticisms levelled at the behavioral approach by economists from the more classical areas of economics, who point out that their approach does yield predictions. Unfortunately these usually turn out to be incorrect, but the idea seems to be that it’s better to be precisely wrong than roughly right.

The kinds of problems that behavioral research runs into can make your head spin. In many cases multiple biases collide, predicting different outcomes. In others, researchers are able to show that by changing the context of their experiments they can reverse results – which may turn out to be equally illogical, but are no less troubling (see: Behavioral Finance's Smoking Gun). In general, behavioral finance describes what's gone wrong but doesn't help predict what's about to happen next.

If we're to put behavioral finance on a solid footing we need to look to the principles of science, and develop testable hypotheses. One of the main concepts behind the scientific method is to look for unifying principles, amongst which is a rule of thumb that prefers a hypothesis which explains the most phenomena using the least assumptions. This is the idea behind Occam's Razor, commonly referred to as parsimony.

This approach has defined the trajectory of scientific knowledge, as we have increasingly found ways of integrating apparently disparate areas of knowledge while reducing the range of underlying assumptions we need to make. There’s no obvious reason why this should be different for behavioral economics – ultimately we'd expect that the vast range of biases should simplify down to a relatively small number of underlying causes.

Genes, Revisted

A couple of recent research papers have made a gesture in the direction of an integrated approach. The first of these starts with a fairly simple hypothesis – that many biases originate in our genetic makeup. We’ve previously seen that genes can explain various types of hormone related bias in behavior (see: Are You A Born Investor? and Craving a High: Trading on Dopamine) so a wider application of this type of idea wouldn’t be at all surprising. In Why Do Individuals Exhibit Investment Biases? Henrik Cronqvist and Stephan Segel looked at the differential impact of genes and education on behavior in non-investment domains and have found a correlation with similar behavior in investment:

“We find that a long list of investment biases, e.g., the reluctance to realize losses, performance chasing, and the home bias, are "human," in the sense that we are born with them. We base this conclusion on empirical evidence that genetic factors explain up to 50% of the variation in these biases across individuals.”

The idea is that investment biases are generated out of more general, non-investment related preferences and that these are genetically moderated. So, for example, the familiarity bias (see: Home Is Where The Risk Is), the tendency to prefer stocks with which we’re personally familiar, is correlated with the person’s preference for where they live and where their spouse originates, and this, in turn, has a genetic basis – at least to the extent that genetically identical twins are more likely to exhibit these biases than fraternal twins.

Noisy Signals, Revisted

A second idea, as a mechanism for integrating biases together, is to look at the way the brain processes information. We’ve already seen that noise can impact information processing at a gross level – by introducing noise into the signals generated by markets it’s possible to mask the underlying information being produced sufficient to confuse investors (see: Idiot Noise Traders). However, information processing limitations should also impact people at the individual level: the brain is an information processing system, and it’s a reasonable theory that it can be impacted by noise sufficient to introduce apparent biases into its outward behavior.

Martin Hilbert has looked at this in Towards a Synthesis of Cognitive Biases: How Noisy Information Processing Can Bias Human Decision Making. In this he argues, and shows mathematically, that introducing noise into the brain’s information processing pathways can theoretically create at least eight different biases. The range of biases he looks at is interesting in that, conceptually at least, they seem to form a distinct sub-set. So, for example, he covers conservatism, aka the underestimation of high likelihood events and the overestimation of low ones, and illusory correlation where judgement is based on a relationship we expect even if it doesn’t really exist.

The paper also looks at the relationship between over-confidence and the hard-easy bias. The former is where we are over-confident about the accuracy of our judgements, while the latter demonstrates under-confidence in comparative situations where the problem faced is very difficult, and over-confidence in the situations where the problem faced is easy; which ignores the fact that everyone else must face the same problem. The difference is context, and Hilbert shows that these biases can be explained as related consequences of noise during memory retrieval.

Towards the Big Picture

Although this synthesis only covers a small subset of the total range of biases it does suggest that many of them may arise from similar causes, and that these causes originate from mechanisms that are already well understood in other arenas. Interestingly, Hilbert is also able to come up with a mathematical definition of the different biases under consideration – which both allows for better empirical investigation and removes some of the ambiguity associated with the often rather vague association of a name with a particular set of behaviors, something usually accepted by researchers without much debate.

These attempts to provide a partially integrated view of behavioral biases are the first, halting efforts to produce a really scientific synthesis of the topic. After all, it’s no good claiming that biases are both irrational and predictable if you can’t then use that information to useful effect. Combining these research ideas gives us an initial suggestion that our external behaviors are biased by noise in the system and that the precise effects will be moderated by our genetic makeup. Neither should be surprising, as both genetic disposition and the laws of information processing are already well understood as limitations on behavior in other sphere of operation.

Of course, these initial ideas will doubtless turn out to be wrong in some interesting and unexpected ways. Yet the basic idea, that we’re creatures sculpted by our genetic makeup and then baffled by our noisy environments is not unexpected. A nice next step would be some ideas about how to use this information to make us better investors.

The hard-easy bias added to The Big List of Behavioral Biases.

Become A Safer Investor – Get Married

noreply@blogger.com (timarr) — Thu, 17 May 2012 05:30:00 +0000

Married CEOs and fund managers take less risks than single ones

Sex and CEOs

Sexual selection – the competition for mates – lies at the heart of Charles Darwin’s theory of natural selection. All things being equal – which they never are, of course – any behavior or attribute which makes an individual more attractive to breeding partners should end up being selected for because the unsuccessful individuals in the mating game leave no offspring.

Given the biological imperative to pass on their genes you’d expect people to fairly aggressive in trying to do so. The evidence suggests that humans, like other species, tend to become risk-takers when confronted with the need to acquire a partner, particularly one of higher status. All of which leads to the slightly odd conclusion that, if you want your money handled as safely as possible, you should look for married managers in stable relationships. Or women.

Risks and Rewards

The original idea behind natural selection was about competition for scarce resources. Food is the obvious resource – but accessing sources of food only keeps you alive, it doesn’t guarantee you’ll manage to pass on your genes. Hence Darwin added the concept of sexual selection, the idea of a competition, mainly amongst men, for access to mates. Sexual selection has been used to explain various animal kingdom oddities like the extravagance of the peacock’s tail and the ridiculous nests of the bower birds: the males are trying to impress prospective partners (see: Advertising on the Handicap Principle).

Michael Baker and Jon Maner in Risk-taking as a Situationally Sensitive Male Mating Strategy suggest that risk-taking is a valuable strategy for males attempting to signal their reproductive fitness:

"Among men, risky behaviors have potential for displaying to potential mates characteristics such as social dominance, confidence, ambition, skill and mental acuity, all of which are highly desired by women seeking a romantic partner ... Because male risk-taking is thought to be derived ultimately from intrasexual competition over potential mating opportunities, we predict that interest in procuring a mate will be associated with increased risk-taking among men".

Their evidence supports this prediction. For those of us inclined to behavioral explanations of most things it's a neat twist that the experiment uses priming to induce the effect: male participants primed with pictures of attractive female faces were more likely to demonstrate risk taking behaviors, once memory effects were taken into account. In essence, participants became more or less of a risk-taker dependent on whether they were exposed to pictures of attractive women. Aren't we sad, guys?

More Cows, Please

This sort of experiment has led some researchers to wonder if this situational risk-taking behavior extends into investment markets which are, after all, the modern equivalent of the primeval jungle. The idea is that although our underlying motivations are the same the particular expression of it will be in ways that are specific to local cultures. So if you live in a society where status is measured in the number of cattle you own then taking risks to acquire more cows is quite likely.

If, on the other hand, you’re a CEO or a fund manager you’re quite likely to judge status in terms of money: and to be prepared to take risks to get more of it. Which is OK, apart from the fact that CEOs and fund managers tend to be in the highly privileged position of being able to take risks with other peoples’ money in order to fuel their need for improved status. If they started trading other peoples' cows in order to get laid there'd likely be an uproar.

The corollary to this speculation is that corporate leaders who don’t have any pressing need to acquire a partner by demonstrating their money fuelled top-of-the-tree status will probably feel less inclined to take risks. All of which leads to the hypothesis that married senior executives will be less likely to be extreme risk takers than single ones. Of course, marriage doesn’t always signal an end to the mating game for everyone but the researchers usefully suggest that the high costs of divorce might be an economic inducement for executives to remain nominally faithful.

Idiosyncratic

The type of risk we’d expect in these situations is what’s known as idiosyncratic risk. Typically we see irrational risk taking behavior created by herding. An extreme example was the dotcom craze where everyone bought the same odd collection of telecom and IT stocks. In that case everyone was taking on risk, but as they were taking on similar risks this can be said to be systematic risk. In that situation idiosyncratic risk was doing something different from the herd – like buying old economy stocks.

Systematic risk isn’t any good to a mate-hunting red blooded corporate leader because it won’t help them stand out from the crowd and generate different returns. This is a competitive market and the alpha executive needs to make more money than everyone else; so they need to take on idiosyncratic risk. This is the idea that Nikolai Roussanov and Pavel Savor have investigated in Status, Marriage and Managers’ Attitudes to Risk. The results are intriguing:

“We find that single CEOs, who are more likely to exhibit status concerns, are associated with firms that exhibit higher stock return volatility and pursue more aggressive investment policies. This effect is weaker for older CEOs. Similarly to corporate CEOs, single mutual fund managers exhibit greater idiosyncratic risk in their portfolio returns. Similarly to the CEOs, mutual fund managers who are single exhibit greater idiosyncratic risk exposure than their married peers.”

Married and Safe

Of course, as ever, correlation doesn’t prove causality, but it’s an interesting finding to say the least. Here we have a situation where competition in one market – for eligible partners – feeds across into the behavior of corporate leaders:

“Single CEOs invest more aggressively (in capital expenditures, R&D, advertising, and acquisitions) and their companies exhibit higher stock return volatility”

The research provides evidence that similar behaviors can be found amongst mutual fund managers. In particular mutual funds run by singletons tend to be less well diversified than those run by married individuals. Even more interestingly – and entirely in accordance with intuition – the same kind of skewed risk profiles appear to hold for individual investors. Single investors are much more likely to be less well diversified and have more invested in their average individual holding than married investors.

Evolution or Retirement

In fact there's plenty of research suggesting that more experienced investors are better diversified and hold less risky portfolios than inexperienced investors. So maybe this is because experienced investors are older and more likely to be married. Or maybe they have children, mortgages and responsibilities. In fact you can think of lots of reasons why risk-taking may be correlated with younger managers, but it all points to the idea that the situation of the controlling individual, be they CEO or fund manager, is relevant to their risk-taking profile.

Interestingly, of course, this research is gender specific, although the findings could read across in investment markets. Nonetheless it does hint at an explanation for why women, in general, seem more risk adverse than men. Sadly if we're generally attracted to risk-takers then this would also explain why we're less inclined to put our capital in the hands of female fund managers. More fool us, because if we can't separate our evolutionary history from our retirement needs then those mate-hungry managers will surely do it for us.

See also: Married Men and Money Management by Josh Brown @ The Reformed Broker.

Related articles:

Greece, Catharsis and the ECB Moneylenders

noreply@blogger.com (timarr) — Mon, 14 May 2012 06:00:00 +0000

Viciously Circular

In the depths of the Great Depression US unemployment hovered around the 25% mark, with 30% of the youth unemployed. Today in Greece the comparable numbers are 22% and a scarcely believable 54% (see: Greek Labour Force Study). Meanwhile another €4.2 billion has been pumped into Greece by the European Central Bank (ECB) via the European Financial Stability Facility, despite the vast protest vote against the externally imposed austerity measures delivered in their recent elections.

Unfortunately this money isn't being used to reflate the economy and maintain the social fabric of the county, it's actually allocated to a “segregated debt service account” which, in effect, is used to repay the debt that the Greeks owe to … the European Central Bank. It’s little wonder that voters have exhibited a longing for catharsis: emotional cleansing awaits.

Injecting Optimism

Much ink has been spilt pointing out that the mess Greece is in is largely of its own making, a combination of fiscal ineptitude and plain fraud. However, most of the Greek populace is guilty of nothing more than an all-too-human tendency to vote for the people who promise them the best futures, and they're the ones who are suffering the most at the hands of the austerity measures. Not only is unemployment raging but there's very little in the way of a safety net: there's limited social security for a year after you lose your job. If you’re a kid who’s never had one, there’s nothing.

The lesson of the Great Depression was that financial policy needs be directed at spending, because as Herbert Hoover discovered, leaving the market to sort itself out doesn't necessarily lead to good results because the downward spiral of the economy all too easily feeds back into peoples’ psychology and exacerbates the situation (see: Time for Shiva and Schumpeter). To drag an economy out of its depths you have to find a way of injecting optimism and confidence into peoples’ outlooks – which is usually translated into injecting money into the economy, hence the ultra-low interest rates and quantitative easing seen in the US, where the lessons of the 1930's still linger.

Austerity Rules

The reaction of the rest of the Eurozone to Greek economic implosion has been to crank up their demands for austerity and destroy any chance of optimism. The current expectation is that to meet basic competitiveness criteria Greek public servants will see another 15% cut in their salaries, on top of significant previous cuts. Of course, this is rational – if exchange rates are fixed and you can’t improve competitiveness then wages must fall.

Well, rationality be damned. What about the human cost? This is economics with the people taken out, and replaced by the ethics of backstreet moneylenders. Increasingly it looks like European leaders are suffering from a bad case of moral disengagement (see: Euphemisms for Morally Disengaged Managers).

Fictional Banking

The problem is that all of the human misery and strife that the fiscal retrenchment is creating is completely pointless because the entire aim of the bailout process is not to rescue Greece but to maintain the fiction that the Greek debt can ever be repaid, thus avoiding the nasty necessity of accepting the eventual inevitability of default. The mere fact that the bailout funds are being laundered in bizarre circular fashion is evidence enough of this.

Meanwhile it appears that the Greek people themselves are an incidental and inconsequential issue in this scheme, which owes more to the money lending tactics of dubious backstreet spivs than it does to the international financial community. Although there’s an argument that there’s not a lot of difference between the two.

Where the Sun Shines

The imposition of increasingly draconian austerity measures, most of which are being borne by the people least able to bear them, has led to a predictable reaction. Let’s face it, if you’re an unemployed 20 year old with no prospects of work – ever – what are you going to do come election time? Are you going to vote for the party that says you have to put up with a lifetime of misery, aka austerity, or are you going to take a chance on a bunch of unknowns whose entire manifesto consists of a single policy – namely, to tell the money lenders to take their money and stuff it where the sun don’t shine?

Of course, the euro-politicians’ response to the democratic wishes of the voters has been to insist that Greece continues to fulfil its obligations, namely to continue to aid and abet them in the gigantic fiction that Greek debt can ever be repaid. In-between times, in order to fulfil this objective, the eurocrats have replaced democratically elected governments in Greece and Italy with compliant technocrats – economists trained in the principles of fiscal rectitude according to the high priests of the economic religion (see: Religion in Econoland).

Democratic Deficits

Fortunately the wonder of democracies is that eventually the voters have their say. Since the start of the 2008 economic crisis we’ve seen governments overturned in Spain, Portugal, Britain and Ireland. In Finland and Belgium nationalist parties have made significant gains, and even Germany faces the rise of the disaffected with the successes of the Pirate party on a manifesto of open source government. The recent election results in France and Greece are simply the latest examples of a dissatisfied electorate making their feelings known. The overwhelming expectation that economic growth can continue indefinitely has been baked into peoples’ expectations, and politicians are feeling the effects of their failure to meet these.

Greece is now a test case: a collision between democratic rights and economic orthodoxy. History dictates that realpolitik will eventually win out: practical considerations of material circumstances will triumph over political and economic orthodoxy, because the alternative is worse. As Alan de Bromhead, Barry Eichengreen and Kevin O’Rourke have demonstrated in Right Wing Political Extremism in the Great Depression:

“Our analysis thus suggests that the danger of political polarization and extremism is greater in some national circumstances than others. It is greatest in countries with relatively recent histories of democracy, with existing right wing extremist parties, and with electoral systems that create low hurdles to parliamentary representation of new parties.

Above all, it is greatest where depressed economic conditions are allowed to persist. “

Catharsis

What Greece needs now is what Aristotle called “catharsis”, an emotional cleansing and a fresh start:

“Catharsis calls for bringing to account those responsible for the crisis’ origins and its consequences. … Catharsis requires greater visibility, efficiency and accountability in a state governed by the rule of law. It also demands a better communication strategy that the sacrifices will pay off, are worth the effort and can indeed lead to ‘resetting Greece’ in the future. Greece needs a new growth agenda and a job creation perspective around which members of society can rally. Catharsis requires a shared sense that everyone can benefit in the long run from short-term sacrifices. This is particularly important for the young, access to education, which pays off, employment opportunities and trust by the new generations in the institutional geography of Greek politics.”

(The Path to Democratically Sustainable Reform in Greece, Jens Bastien and Kalypso Nicolaidis)

Europe’s leaders now appear to paving the way for Greece to exit the euro and the Eurozone, in what looks like a deliberate ratcheting up of the pressure on Greek voters. However, with no alternative, Greeks are likely to reach for catharsis in the only way they have left. The people running Europe need to be careful what they wish for, because where Greece leads others may soon follow.

Is Your CEO A Psychopath?

noreply@blogger.com (timarr) — Thu, 10 May 2012 06:00:00 +0000

“She was interviewing a psychopath. She showed him a picture of a frightened face and asked him to identify the emotions. He said he didn’t know what the emotion was but it was the face people pulled just before he killed them.”

(The Psychopath Test, Jon Ronson)

A Boardroom Blitz

Psychopaths lack empathy, are pathological liars, have an enormous sense of self-worth, are impulsive, irresponsible and won’t accept responsibility for their own actions. They make up 1% of the total population, 25% of the criminal population and, by some accounts, 4% of corporate boardrooms.

Of course, someone who believes that the only role of business is to maximise profits, regardless of the human cost, is only following the mantra of standard economic theory. On the other hand, an academic discipline that provides covert justification for a behavior pattern that would get you locked up outside corporate HQs may just have reached the end of its natural lifespan.

Hare Brained

The absolute standard of psychopathic tests is that invented by Bob Hare, a Canadian who’s made it his life’s work to figure out how to identify the conniving devils. He first realized that they were wired differently from other people when he started giving prisoners electric shocks. He warned them first, and discovered that psychopaths displayed no fear at all at the impending pain. Even more remarkably when he did this again they still weren’t bothered – unlike their terrified non-psychopathic fellow inmates.

Perhaps the bottom line is that psychopaths don’t have a conscience. For anyone who does this is almost as puzzling as the alternative is to a psychopath. But put this in context – imagine you’re dealing with a person who is superficially normal but actually has no fellow feeling whatsoever. Remove all of those trust mechanisms that you rely on and consider only that you’re dealing with someone who simply doesn’t care. Basic economic transactions rely on common standards of trust, remove those and you have an imbalance that's dangerous for all normal people.

Of course the intrinsic traits of a psychopath are much like those of the modern corporation. We touched on this in Frankenstein’s Corporations, the idea that if you test the modern firm for psychopathic tendencies they score very highly. Which means, ultimately, that the people running these companies must behave in a similar fashion.

Directors in Disguise

Now this doesn’t automatically imply that everyone running a company is a psychopath. The economic pressures to behave in a way that meets the needs of the corporation in the brutal dog-eat-dog world of modern business are enormous – consider this neat study by Eric Gilbert that shows that phrasing in emails at Enron can predict the status of an employee. We conform to the roles expected of us.

So, placed in a position of corporate responsibility, many of us will be forced at times to behave a bit like psychopaths. Can you imagine a better place to hide if you’re a real psychopath? As Jarolaw Groth puts it:

“Their behavior is often regarded as evidence of traits which are sought-after in employment, in particular in senior positions, which have a broad scope of action and less clearly-defined duties, as well as helping them keep their jobs and climb the career ladder.”

This is a nasty dilemma, because if a corporate psychopath has exactly the kind of attributes necessary to be successful in a corporate environment then you’d tend to expect more of this ilk to succeed in attaining the highest positions in our major corporations. However, there’s an important caveat to this as Clive Boddy points out:

“At first view the existence of Corporate Psychopaths would appear to provide evidence for the bounded rationality of managers. However because they are ruthless and largely unaffected by the emotional consequences of what they do, they may actually operate as almost perfectly rational beings, with the important caveat that in making rational decisions they will put their own interests before those of the corporation they work for”.

Parasitic Managers

As this presentation from the UK’s Institute of Risk Management suggests there are a range of possible problems with psychopaths in the boardroom. These include risky decision making, unethical behavior and a lack of loyalty to the company and stakeholders: does this sound familiar? One of the problems with these people is they’re very good at managing upwards – they charm superiors, manipulate peers and abuse subordinates. Once they get in senior positions it’s easy to see how problems could escalate.

To say that this is an ugly situation is to put it mildly. If we can’t actually tell the difference between a corporation behaving in its own self-interest and a psychopathic CEO operating in their own self-interest then it suggests that there’s a serious problem with the way that our corporate institutions are functioning. And maybe an even more serious problem with the economic fundamentals that lie behind them, because a system that can’t tell when it’s being parasitized is going to die.

Destabilized

Which is exactly what some people are suggesting: that the recent failures of major corporations, accompanied by leaders departing with huge bonuses and no signs of regret or remorse are an indication of exactly how deep this particular malaise goes. As Boddy has related in The Corporate Psychopaths Theory of the Global Financial Crisis there’s a credible analysis that argues that the rise of psychopathic managers has been aided and abetted by a economic system that makes firms fundamentally unstable places to work:

“Prior to the last third of the twentieth century large corporations were relatively stable, slow to change and the idea of a job for life was evident, with employees gradually rising through the corporate ranks until a position was reached beyond which they were not qualified by education, intellect or ability to go. In such a stable, slowly changing environment employees would get to know each other very well and Corporate Psychopaths would be noticeable and identifiable as undesirable managers because of their selfish egotistical personalities and other ethical defects.”

So the argument is that the rise of the mantra of value maximisation, increased corporate instability and the ever increasing turnover of staff has allowed corporate psychopaths to flourish. Eventually they manipulated their way to the top of corporations and have promptly done to them what they’ve always done to their colleagues whenever they’ve had the chance – screwed them royally.

Skinned Alive

If correct this is a wonderful example of how economists should never be allowed near anything to do with the real economy. The ruthless pursuit of profit, without moral considerations, was a view expounded by Milton Friedman (see: Moral Corporations: An Oxymoron?) and was converted into a theory of value maximisation through incentivisation of managers, supposedly to align their interests with those of shareholders (see: When Incentives Go Bad).

However, to every action there is an equal and opposite reaction and the net result of all of this amoral profit maximisation has been to destabilise the psychological foundations of the corporations the world’s economy relies on. Most CEO’s aren’t psychopaths, but an economic system that ensures we can’t tell the ones are from the ones that aren’t is rotten to the core.

The economists were wrong because they were operating on a flawed assumption of human rationality and an inadequate model of economic behavior. Trust needs to be earned and shouldn't simply be offered to the highest bid or fiercest cost-cutter. What you get when you have a human who is perfectly rational and utterly self-interested isn’t a ideal economic specimen of the species. No, it’s Hannibal Lecter in a business suit.