Writer108’s thoughts…

The Real Dharma of Capitalism (Or, if CSR is the answer, we are asking the wrong question)

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As the dust settles from the financial crisis and attention turns towards rebuilding economies, a fundamental question being asked is: What next for capitalism? Globalisation has raised the stakes and costs of financial crisis. Climate change calls for a reevaluation on resource exploitation. And the Internet Age has increased transparency and the impact of negatively perceived practices. This backdrop has led many to question self-interest driven capitalism’s ability to address the challenges of the 21st century.

Hardcore lefties are quick to sound a death-knell, pointing out the ‘Washington Consensus’ of deregulation and privatisation bears little resemblance to the state-owned, deficit-ridden Western economies that once espoused it. More pragmatic commentators, recognising the benefits of private ownership and markets, have instead looked for better ways to reduce negative externalities and increase the intersection between the interests of society and enterprise. This has led to Corporate Social Responsibility (CSR) being heralded as the way to ‘fix’ capitalism. At the extreme, protagonists argue capitalism’s failures are a creation of the West and we must look East for solutions, declaring ‘doing the right thing’ is the essence, or, Dharma of capitalism – synonymous with long-term profit maximisation.

However, the suggestion capitalism is the economic equivalent of a Pot Noodle, where we can just add water (or in this case, CSR) and everything will taste good is not only naive but dangerous. Adding a set of ethical responsibilities to the profit motive is not a magical band-aid capable of healing the rift between enterprise and society, rather it is akin to dressing your Nan up in the latest Marc Jacobs creation and expecting her to win ‘Britain’s Next Top Model’ – sorry, it ain’t gonna happen.

Protagonists of Social Responsibility 2.0 (or 3.0, 4.0…I lose count) would have us believe that whilst the old model of CSR – based upon disconnected and delegated philanthropy – was a cost-centre, the new model, ‘Strategic’ CSR – the realisation of triple bottom-line benefits – is aligned with profit maximisation and in the long run, doing the right thing is the right choice for profit. That’s a great soundbite, but in practise, it’s useless; when corporate and societal interests are perfectly aligned, CSR is defunct, and when they diverge, CSR is inert.

When the interests of business and society are perfectly aligned, the invisible hand directs affairs towards the profit and social welfare maximising choice, without the need for a CSR intervention. The majority of successes CSR advocates claim as their own, are in reality, just traditional profit-maximising initiatives with good branding – even the Toyota Prius was not developed until it became a commercially viable project. Furthermore, when CSR crusaders claim they help address one of the major criticisms of capitalism – a tendency towards short-termism, they are guilty of deceit – telling business leaders not to be short-sighted is not the same as telling them to be socially responsible, it is just telling them to be better at business.

Even the slightest hint of divergence between the interests of society and business and the whole CSR rubric falls like a house of cards. Consider the decision facing executives at a fictitious pharmaceutical company who must choose between two options – one project which has a projected return of £20 million and the potential to save 150 lives or another with a return of £30 million, which saves only 50 lives. Which project do you choose? The answer may be obvious to some (but not others). What if there is a third option – a project yielding £100 million, which saves just 1 life. How do you choose now?

Whilst ‘experts’ are quick to publish book after book proposing frameworks for ‘triple bottom-line’ decision-making, none have the elegance or effectiveness required to replace the profit-maximising model. Social costs cannot be ignored in decisions, but they are too nebulous to be factored explicitly into analysis. The moral calculus needed to weigh one social benefit against another, or against its costs, has yet to be developed – and ‘consultants’ should stop filling reams of paper with anecdotal vagaries until one does.

The problem with the triple bottom-line approach is that systems developed around multiple objectives will always lead to ambiguity, and in practise, accountability to multiple stakeholders amounts to accountability to none; providing managers with opportunities to game the system, such as greenwashing or claiming profits are down, due to the need to satisfy some other stakeholder.

The truth is, whilst CSR claims to be a distinct paradigm, for it to be acceptable, it is incapable of operating on a point of principal, confined to parameters set by the traditional model of capitalism. George Bernard Shaw, once claimed whilst on an ocean voyage he met a celebrated actress and asked whether she would be willing to sleep with him for a million dollars. She was agreeable. He followed with a counterproposal: ‘What about ten dollars?’. ‘What do you think I am?’ she responded indignantly. He replied, ‘We’ve already established that — now we’re just haggling over price’. The (triple) bottom line is CSR has a price, and that price is profit. Advocates may assert being a good corporate citizen can create a strategic advantage, however, this is little more than a consultant’s promise of a free lunch, overlooking that at the limit, when every company behaves in a socially responsible way, we hit saturation and no advantage exists.

CSR supporters assert it is a refreshingly new and inclusive approach. The reality is it is just a rehash of an old misguided perspective on the relationship between business and society. Milton Friedman famously wrote the ‘social responsibility of business is to create profits’. We have come a long way since Friedman’s comments, but the tacit admission of guilt that CSR creates – implying business leaders are socially irresponsible without it, is misleading and panders to stereotypical views of ‘evil’ corporate figureheads who rape and pillage society for their own gains. This perception is reinforced by the focus of the CSR community, who write almost exclusively for the benefit of business leaders, based on the premise – it is the leaders whom are bad, and if we encourage better behaviour, this will reduce negative externalities and increase social welfare.

This premise misunderstands how capitalism works – leaders do not control the capitalist agenda, profit is the signal that drives commerce and one of the major challenges that executive-focused CSR fails to address is the cognitive dissonance of consumers, who indicate concerns for issues such as climate change and labour exploitation, but are often unwilling to vote with their wallets for change. In the same way Toyota began mass-producing the Prius when it was cost effective, behavioural economists argue consumers only started buying it when the social prestige of doing so out-weighed the drawbacks.

CSR advocates live in a simplistic world where business leaders need only develop the will to do the ‘right thing’, glossing over the challenges of understanding causality and identifying the ‘right’ course of action. John Manville Corporation, in the 1950s produced asbestos, unaware of the potential of the product to cause cancer and other illnesses. Thirty years later, the lawsuits from those afflicted with asbestos-related disease have driven the company to bankruptcy – was this really a case of social irresponsibility that could have been fixed by handing the CEO a book on Social Responsibility 2.0?

This good vs evil paradigm also suggests when activists challenge an ‘evil’ corporation and force it down a more socially responsible path, they fully understand cause and effect and if the corporation fails to placate their agenda they are socially irresponsible. But is this always the case? Whether its Greenpeace forcing Shell’s hand on Brent Spar, or Tata forced to relocate a West Bengal plant, activists have been shown to act in socially irresponsible ways – social norms can, and often do, operate in ways counter to social welfare. For example, if an NGO were to resell confiscated ivory, this would be frowned upon by the public for being ‘immoral’, even when it would lower the price of ivory and discourage poaching.

Perhaps the most damning indictment of CSR are the experts who proudly claim they are capitalists. In an effort to gain credibility and acceptance, CSR experts employ a ‘do not fear us, for we are one of you’ tactic. However, this approach shows CSR up for what it really is – an example of human nature’s ultimate frailty in action.

The experts who claim capitalism has simply lost its direction, fundamentally misunderstand what capitalism is. Capitalism is a system for organising the means of production – nothing more, nothing less. This is a ‘grow or die’ system with the exclusive objective of capital accumulation. Capitalism has not lost its way – capitalism is a system and like any system its sole objective is to exert control. Those who try to attach virtues such as honesty and honour to capitalism are performing the ultimate slight of hand – a system cannot be honourable or compassionate, these are human characteristics not systemic.

The American economist John Kenneth Galbraith once said ‘Under capitalism, man exploits man. Under communism, it’s just the opposite’ and in the final analysis, the Dharma of capitalism, is the same as the Dharma of socialism, is the same as the Dharma of government regulation and is the same as the Dharma of CSR – or any other system – it is the Dharma of control. Capitalism seeks to control the means of production. CSR seeks to control the means by which production is controlled – its just layers of control.

Those that claim the challenge is about getting to the right mix between wonton self-interest and virtuous behaviour are missing the point. Thomas Jefferson once said ‘I hope we shall crush … in its birth the aristocracy of our moneyed corporations, which dare already to challenge our government to a trial of strength and bid defiance to the laws of our country’. The truth is, the war was never between virtue and vice, but has always been between those that control and those that want to control, CSR is just another challenger on the battlefield.

When CSR advocates claim they have a way to fix capitalism, what they are really saying is they believe they have a way to control capitalism. Unfortunately, the reality is there exists no system for making people do the right thing. If we want to address unscrupulous and socially damaging behaviour we could implement regulations where the cost of such activities would be so high as to discourage them. However, the truth is there are limits to the level of control even the most powerful social entity – government, can exert. As a result of this inability to exert full control, in this war, there are no winners.

CSR advocates black-label anyone who argues against it. However, the argument is not that business should be allowed to impinge on society at its discretion and subject it to any form of negative externality. Adam Smith argued the invisible hand, destroys the possibility of a decent human existence ‘unless government takes pains to prevent’ this outcome, and Peter Drucker claimed ‘without a community there would be no profits’. But the point is, any solution based on exerting control over capitalism, whether it is the stick of government regulation, or the carrot of CSR, is doomed to fail, as it is just an attempt to control control, and as our parents always told us, two wrongs do not make a right.

If we really want to do good, the best thing we can do is break the cycle and redirect our propensity to control upon ourselves and exert some self-control – leading by example. Unfortunately, it appears CSR consultants, like all snake-oil salesman, cannot control themselves when it comes to wasting countless pages and devising modern day mousetrap models and frameworks to ensnare and control the actions of others.

Written by Brijesh Malkan

November 3, 2010 at 9:07 pm

Kartik – rekindling a basic human need

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Kartik is my favourite month of the year. It arrives at my favourite time of the year – the start of Winter (I prefer Winter to Summer, maybe there is a correlation with my being a Winter baby. I have not found an academic study to back this up, but I am sure one exists somewhere!). It is also the time of the year when I have the opportunity to rekindle a basic human need – increasing personal happiness.

The month of Kartik is well-known for the Kartik-vrata – similar to the Christian month of Lent, Vaishnavas are invited to undertake charitable acts and give up luxuries in order to improve the lives of others and develop their personal spirituality.

Whilst these acts are often perceived as sacrifices – acts of kindness with no desire for personal reward, studies have shown undertaking Kartik-vratas can increase personal happiness.

Consider for example, the act of charity. In numerous academic studies, charitable acts have been shown to increase personal happiness. Perhaps the most compelling example is provided by research conducted at the University of Oregon. In one experiment, macroeconomist William Harbaugh and his colleagues gave participants $100 and wired them up to a brain scanner. Participants were first instructed to give some of the money away via a mandatory tax to help those in need. They were then told they could decide whether to donate the remaining balance in charity or keep it for themselves. The scanning result revealed two ancient regions of the brain – the caudate nucleus and nucleus accumbens – became active when participants witnessed their money going to those in need and the regions were especially busy when they donated money voluntarily. What is interesting is these two regions also ‘fire’ when our most basic human needs are met, such as when we eat tasty food or feel valued by others – suggesting a direct and deep mental link between helping others and personal happiness.

What about giving up luxuries? Surely actively doing something is better than giving something up? As it turns out, the act of giving up something we value is a deeply powerful way of increasing personal happiness.

Behavioural economists and psychologists have long known and studied a paradoxical trait of human behaviour. According to neoclassical economics, the price someone is willing to pay for something should be the same as the price they would be willing to accept to part with the same good. For example, if you buy a shiny new iPad for £400, you should be indifferent to someone offering you the same amount to buy the item off you (assuming you can replace it with no difficulty). However, behavioural economists have found we dislike losing something much more than gaining the same item. Academics speculate this has something to do with hard-coded hunter-gatherer instincts and have coined the term loss aversion to describe the behaviour. In addition, we not only dislike losing things but once we own something we tend to attribute extra value, just because it is ours. In experiments, researchers have shown this endowment effect – the attribution of extra value to items just because we own them – and loss aversion mean giving something up is much more difficult for us than doing something new.

This behaviour has been directly linked to materialism – the more materialistic we are, the more difficult we find giving up. Furthermore, materialism has been directly linked to personal happiness – the more materialistic we are, the less happy we tend to be. For example, in one experiment by Elizabeth Dunn from the University of British Columbia, participants were asked to rate their happiness, state their income, and provide a detailed breakdown of the amount spent on gifts for themselves, gifts for others, and donations to charity. Time and again, the same pattern emerged. Those who spent a higher percentage of their income on others were far happier than those who spent it on themselves. Furthermore, those who scores highly on materialistic personality traits tended to be the most self-centred and spent the least on others.

Moreover, the effect was not limited to monetary acts. In another study, a group of participants performed five non-financial acts of kindness each week for six weeks. These were simple things, such as writing a thank-you note, giving blood, or helping a friend. Some of the participants performed one of the acts each day, while others carried out all five on the same day. Those who performed their kind acts each day showed a small increase in happiness. However, those who carried out all their acts of kindness on just one day each week increased their happiness by an incredible 40 percent! This reinforces the importance of focused and intense periods of sacrifice, such as those undertaken in Kartik.

So this year, as you look forward to offering candles to their Lordships, why not go a little further and set more demanding Kartik-vratas – it will help kindle the flame of personal happiness.

Written by Brijesh Malkan

October 22, 2010 at 4:18 pm

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A brief history of decision making – Why we prefer to be precisely wrong than vaguely right

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Ask an economist how we make decisions and she is more likely to draw a graph or quote a mathematical theorem than to speak plain English. Part of the reason for this is the way in which the ‘dismal science’ has evolved.

Decision-making theory in its modern form is often traced to the 18th Century and the writings of Adam Smith, summarised by the following sentence from his most famous work ‘The Wealth of Nations’: ‘It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest’. Smith’s work set the foundations upon which, neoclassical economics is built – the rationalist perspective.

The rationalist view of human behaviour, dubbed ‘homo-economicus’, states human beings act in the interests of maximising personal happiness and make decisions based upon self interest and profit maximisation.

During Smith’s lifetime, the Dutch mathematician Daniel Bernoulli, built upon this view and explained maximising personal happiness is not synonymous with maximising personal financial gain. According to Bernoulli, rational decisions are made to maximise perceived utility not absolute profit, and this proposition was the foundation of the law of diminishing returns – why we do not derive the same level of happiness (utility) from the purchase of a third Buggati Veyron, as from the first. Rationalists use expected utility theory to explain why two people – both acting rationally, may choose to make different decisions when presented with the same options – as value lies in the eye of the beholder and is determined by personal preference and taste.

Whilst the rationalist view is based on rigid assumptions that may not exist in practise, it enabled economic theorists, inspired by the natural sciences (in particular, Physics), to formalise economics with models, theorems and graphs – improving credibility and acceptance. In the 20th century, theorists such as Samuelson, Arrow and Friedman worked hard to mathematically represent rationalist economic theories.

However, despite its popularity, neoclassical economics has not been without critics who point to one fundamental shortcoming – it fails to reflect the true reality of human decision-making. Critics argue economics does not hold a monopoly on decision-making theory, and psychology – the study and analysis of human behaviour, also has something to say on the subject.

By the mid-20th century this criticism led a number of theorists to look to synthesise the economic decision-making model with research from psychology, and amongst the synthesisers, Herbert Simon and the ‘new institutionalists’ are prominent. Simon agreed with the basic rational model, but argued rationality was ‘bound’ by the amount of information available on potential choices and ability to evaluate options. According to Simon, when a decision-maker was not in possession of ‘full information’, they will not select the utility maximising option, but the most rational choice based upon information available and comprehendible. For example, when selecting car insurance, due to the sheer number of insurers and difficulty of direct comparison, a rational person may not be able to choose the most applicable policy at the cheapest price. Furthermore, due to the time and effort required to evaluate each potential option, a person may self-impose restrictions upon their rationality. The theory of ‘bounded rationality’, developed by Simon in the 1950’s explains why many people stick to their current provider and demonstrates the attractiveness of price comparison websites, which help remove some of the obstacles restricting fully rational choices.

The concept of bounded rationality helps distinguish decisions made under two different conditions – where the full set of choices and outcomes are knowable, and where they are not. This, according to the American Economist and contemporary of John Maynard Keynes, Frank Knight, was the distinction between risk and uncertainty. In his seminal piece on the subject ‘Risk, Uncertainty and Profit’, Knight wrote ʻUncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated…. The essential fact is that ‘risk’ means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating…. It will appear that a measurable uncertainty, or ‘risk’ proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all’.

According to critics, neoclassical and new institutionalist models of decision making are great when the full set of choices and outcomes can be known prior to the decision, such as deciding on whether to bet on a coin toss, but the real world is more complex and under conditions of Knightean uncertainty, rational choice – bound or otherwise, does not reflect the reality of decision making. As Naseem Taleb, who came to prominence for his book ʻThe Black Swanʼ states ʻLife is not a laboratory in which we are supplied probabilities. Nor is it an exercise in textbooks on statistics. Nor is it an urn. Nor is it a casino where the state authorities monitor and enforce some probabilistic transparency.ʼ

The financial historian and author Peter Bernstein wrote in ʻAgainst the Godsʼ, the evidence ‘reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty’. An understanding of these ‘patterns of irrationality’ was the next major breakthrough in decision-making, made by an academic who claims never to have taken an economics class at university. Daniel Kahnenmanʼs contribution to decision-making theory was the finding that in many instances we make non-rational choices not due to the amount of information available, as Simon contended, but the way in which we process that information.

Kahnenman and his colleague Amon Tversky, demonstrated that under certain conditions, we do not evaluate choices rationally – irrespective of whether we are aware of the full set of options or not. For example, under conditions where a quick response is required, we often rely on information shortcuts, such as ‘following the crowd’, rather than evaluate options independently (rationally). These shortcuts, for which Kahnenman and Tversky coined the term ‘heuristics’, implying hard-coding and automation, can serve us well. For example, when we see people running out a building screaming ‘fire!’ it normally makes sense to just ‘get the hell out of there’, rather than rationally verify the existence of a fire and evaluate options.

However, like any rule of thumb, relying on heuristics can lead to mistakes and the problem is when we need to make a quick decision, or are faced with information overload, we often subconsciously defer decision-making to heuristics and this leads to what Kahnenman described as cognitive biases – or Bernstein’s predictable patterns of irrational behaviour.

Kahnenmanʼs work, for which he won the Nobel Prize, is the basis of the field of Behavioural Economics and the field provided homo-economicus the hero of neoclassical economics with his antithesis – homo-irrational. This has led to many academics taking sides – either rational, or irrational, with the ensuing war spilling over into the mainstream, with writers and academics such as Malcolm Gladwell, Dan Ariely and Richard Thaler gaining prominence for leading the charge against rationalists.

The conflict between rational and irrational has much to do with the historical development economics and psychology. Whilst economic explanations are normally mathematical, for psychology – which was inspired by experimental traditions not mathematical structure, theories and explanations are verbal constructs. These diverging approaches led to a war between mathematical precision and verbal vagaries.

This conflict also explains the difficulty of reconciliation and why, despite the existence of compelling evidence to discredit rationalist theories, these models still dominate the intellectual landscape. As the nobel prize winning economist Amartya Sen wrote ‘It will not be an easy task to find replacements for the standard assumptions of rational behaviour … that can be found in the traditional economic literature, both because the identified deficiencies have been seen as calling for rather divergent remedies, and also because there is little hope of finding an alternative assumption structure that will be as simple and usable as the traditional assumptions of self-interest maximisation, or of consistency of choice’.

The problem with rational models is not they are wrong, but they are precisely wrong. Mathematical models are extremely attractive because they provide the illusion of certainty and control – playing into the hands of the ultimate frailty of human nature – the propensity to control. Psychology-based models with their verbal explanations and ambiguities, fail to pander to the control propensity – rather, they paint a picture of a complex world where causality is difficult to understand, a world which does conform to models and rationalistic assumptions.

As Richard Thaler once famously explained: ‘It’s a choice between being precisely wrong or vaguely right’. Unfortunately, our propensity to control seems to lead us by an ‘invisible hand’ towards the illusion of precision.

Written by Brijesh Malkan

October 21, 2010 at 7:02 pm

Why the vote of financial markets matters…and why this doesn’t really matter

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‘Hopefully, the [policy] changes proposed will make India a more market-friendly investment destination’ – recent comments made in The Times of India by the former joint secretary to the Indian finance ministry.

These comments reflect a commonly held belief about the relationship between democracy and financial markets – markets are important, and policy-makers readily submit to their will, implementing ‘market-friendly‘ policies to encourage investment, marginalising (screwing) innocent voters in the process.

This belief makes assumptions of how government policy influences investor behaviour. The theory is, rational investors associate ‘Left’ governments with larger public spending programs and borrowing – resulting in higher levels of inflation, government spending, and default risk. Right governments, depicted as encouraging private investment and tighter fiscal budgets are deemed more ‘market-friendly’. The prognosis is, Leftist policies curtail economic growth by discouraging investment and the fear expressed by critics of free-market capitalism is market openness renders impossible public provision of education, health care, income redistribution, and active labor market policies— all hallmarks of the contemporary welfare state.

However, whilst commonly held, evidence to back up this truism is scant. For example, after voters in the United Kingdom and Australia had their say in recent elections – both returning hung parliaments, all eyes turned towards the other entity to which governments are allegedly held accountable – the financial markets, who were expected to strike with fury against voter indecisiveness.

A day before the UK elections, The Financial Times reported a leading investor’s comments as: ʻAny form of hung parliament is worse than almost anything I can think ofʼ. On the day after the election The Guardian reported a leading economistʼs confirmation: ʻYou probably couldn’t get a worse result for the market with no party gaining a mandateʼ.

The outlook for Australia was equally bleak. If you did a a search on Google News after the Australian elections you were confronted by news headlines such as ʻAustralian election: dollar falls at prospect of hung parliamentʼ and ʻHung parliament to hit Australian markets: analystsʼ.

However, both UK and Australian markets failed to suffer the meltdown predicted by analysts and pundits. Have we got the relationship between Financial Markets and Democracy wrong?

Two leading academics from the United States say yes. William Bernhard and David Leblang, in their book ‘Democratic Process and Financial Markets: Pricing Politics’ explain lack of evidence to support the ‘market-friendly’ argument is due to a fundamental misunderstanding of what drives investor behaviour: capital markets act as an intermediary for risk transfer – from those who create it, to those willing to bear it. Here, the primary currency is not outcomes, but predictability – the more predictable an outcome, the less a risk-bearer will be rewarded. Bernhand and Leblang’s studies have shown market movements are correlated with the level of uncertainty of political outcomes, not actual policies. According to Bernhand and Leblang’s theory, the reason there was no great sell-off after the hung parliaments was because they were the ‘predicted’ outcomes – well publicised in the media and by ʻexpertsʼ.

Conventional wisdom states politicians can increase investment with the implementation of ‘market-friendly’ policies. Bernhand and Leblang’s research turns this conventional wisdom on it’s head and they state: ‘ Interestingly, many of the political and economic factors—including inflation, partisanship, and fiscal policy— deemed highly salient to investors…are not statistically associated with stock market valuations’. Market’s simply do not care as much about actual policies (be they left or right of centre) as we think they do.

Critics argue this lack of statistical evidence provides the strongest evidence of the subversive influence of investors – due to the need to appease investors, Leftist governments can no longer afford to ‘act Left’, and global democracy has converged upon market-friendly policies. The consensus is – ‘whoever wins, the markets get in’.

There are some elements of truth to this ‘end of history’ argument as even with the dismantling of the New Labour machine, the UK Labour Party bares stark resemblance to Socialist ideals. However, another problem with the ‘market-friendly’ argument is the assumption investors are rational in their behaviour and intentionally control the political agenda.

The field of behavioural economics, made famous by celebrity authors such as Malcolm Gladwell and Dan Ariely, has developed a large body of research calling into question the rational behaviour of ‘homo-economicus‘ – the holiest tenet of neo-classical economics. According to behavioural economists, when confronted with uncertainty or information overload we often defer decision-making to rules of thumb and information shortcuts (known as heuristics). The problem with relying on heuristics is they can lead to irrational or biased behaviour – known as cognitive bias. As the financial historian and author Peter Bernstein wrote in ʻAgainst the Godsʼ, the evidence ‘reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty’.

Whilst the modern-day trader is likely to be more Oxbridge than East London barrow-boy, two essential characteristics still dominate the role – the ability to process large amounts of information quickly and the need for decisive acton amidst uncertainty – in today’s markets a moment’s hesitation or dithering can cost a trader his job, or his firm millions. These conditions are precisely those that encourage ‘fast and frugal’ decision-making and it should come as no surprise the depth of heuristic usage by investors has resulted in the creation of a discipline devoted to its study – behavioural finance. Far from being cold and calculating sharks, ready to bankrupt a country at the mere whiff of Socialist policies, behavioural finance has shown investors are prone to behave in inconsistent and irrational ways.

Consider for example, the current price of Greek Government bonds – trading at yields four times higher than UK Government debt – implying Greek debt is 4 times more risky than UK debt. However, is this an accurate picture? No, according to one leading economic journalist who recently wrote in The Telegraph: ʻUK house prices look likely to fall, or at least stagnate, for some years, while the outlook for Greek debt is in reality much better than generally appreciated: the chances of default, even in the form of an agreed restructuring, are a good deal more limited than the markets seem to imagineʼ.

So what is driving this price? Behavioural experts argue the current price is an irrational overreaction due to heuristics that affect our ability to predict future events – in this case, the likelihood of Greek Government default.

When trying to predict the future we look to past experience for guidance. The basic mechanism relies on how easily we recall previous occurrences of similar events – the greater the ease of recall, the greater we assume the frequency of occurrence. For example, if we easily recall times when it has rained in April, we increase our estimate of the probability of April Showers. Reasonable enough? It would be except for one problem – we do not remember things easily just because they occur more often. Research has shown our ability to recall events is based on factors such as how recent the event was – overweighting the probability of events recently experienced, how vivid the event was – overweighting the probability of descriptive and emotionally charged events, and finally how much the event makes sense – overweighting the probability of events explained easily. This bias (known as availability bias), explains why air-travel dropped following 9/11 despite increased security reducing the risk of another attack and explains why Adam Johnson is considered a goal-scorer extraordinaire despite scoring only two goals for Manchester City and England (at the time of writing) – because media stories of these events dominate our minds, increasing our perception of how often these events occur. As Warren Buffet once remarked: ‘People tend to underestimate low probability events when they haven’t happened recently, and overestimate them when they have’.

Over the past year, stories of the Greek financial tragedy have dominated the media. This has led to an availability bias – where recent and more salient information about Greek fiscal mis-management takes precedence over the fact Greece has never defaulted, lowering demand and the price investors are willing to pay.

Another reason for widespread use of heuristics is due to the difficulty in understanding political information. For an investor to act rationally they must be capable of correctly understanding information and anyone who has sifted through a Party Manifesto or watched Question Time will know attempting to draw concrete conclusions from the words of politicians is akin to catching hot air with a butterfly net. This challenge is amplified in the age of the Internet and 24/7 news, where it is practically impossible for investors to be fully cognisant. As a result, investors tend to rely on a few trusted sources for information – such as Bloomberg and Reuters.

Furthermore, the performance measurement and incentive structure governing the industry means investment professionals do not worry about absolute profits or losses, but how they perform relative to other fund managers. In a year characterised by poor market performance, a 3 percent return may place a manager in the top half of performers; but in a year characterised by good market performance, the same return will doom an investor to the bottom half. The philosophy is ‘better to be wrong in a group than wrong alone.’

The result of using the same news sources and penalties for going against the grain is investors are more likely to ‘follow the crowd’ and make similar investment decisions. This behaviour results in one of the most common market anomalies rationalists fail to explain – momentum.

Momentum is the tendency for prices to rise and fall in the same direction over extended periods of time. According to the rationalist view, prices ‘should’ only change when new information is available – such as company forecasts or interest rate changes, and price rises should not result in further rises in of themselves. However, in reality momentum is an observed phenomenon and the popularity of momentum investing has led Morningstar to begin providing stocks with a ʻmomentum ratingʼ and most rationalists accepting the behavioural explanation for momentum – a cognitive bias to follow the crowd, known as herding.

When investors all act the same, they move the market in the same direction. When investors act on the belief securitised sub-prime mortgages are risk-less investments offering superior returns or junk bonds not worth the paper they are written on (depending on which side of the financial crisis we sample opinion from), the impact on prices is amplified. As Jeremy Warner, The Telegraph’s Assistant Editor, recently commented ‘Markets frequently get it completely wrong, and both on the upside and the downside have a tendency to extreme overshooting’. These views reflect the theories of the American economist Hyman Minsky, who argued bubbles and shocks do not result from external factors, but are part and parcel of the normal life cycle of the markets. According to Minsky ‘Stability was unstable’.

The herding bias has been used to explain a number of financial crisis – including the Asian and Mexican crisis and the IMF recently acknowledged its impact on emerging markets, providing further support for the belief political parties actions to encourage investment may play second fiddle to the irrational biases of investors.

The problem with irrational behaviour is it often make the irrational beliefs they are based on come true. The Yale professor Robert Shiller, who, in his book Irrational Exuberance, was most prophetic of the recent financial crisis, coined the term ‘attention cascade’ to describe the behaviour of investors – an attention cascade is the herd instinct in action; when many people believe something the belief becomes exponentially attractive for no other reason than many people believe it. The problem is cascades – rational or otherwise create self-fulfilling prophecies and are supported by another cognitive bias known as confirmation bias – once a belief is in place, we look for information to support it, reinforcing convictions.

So, the warning for policy-makers is when investors all believe your policies are ‘market-friendly’ and increase investment, this may be great – but be careful, as when and how investors decide conditions are ‘unfriendly’ is beyond your control.

This should be where this article ends – the conclusion should be investors are an irrational bunch and ‘caveat emptor’ – buyer (policy-maker), beware. The advice to policy-makers should be to protect their positions from investor influence – and to a certain degree this has been the case. Politicians are in the business of power – as the American economist, Frank Knight once remarked ʻThe probability of the people in power being individuals who would dislike the possession and exercise of power is on a level with the probability that an extremely tender-hearted person would get the job of whipping master in a slave plantationʼ. The idea politicians would submissively hand over decision-making power to ‘the markets’ overlooks shared incentives – investors want greater predictability in policy decisions and politicians want less decisions judged by the markets.

These shared incentives have led to a number of institutional reforms. For example, as a result of the creation of an independent central bank, it is impossible for a UK political party to campaign on a low interest rate promise or be solely blamed for rate change decisions. In addition institutional reforms such as electoral reform and cross-border economic coordination (such as the formation of the Eurozone) further reduce political uncertainty and market judgement.

However, whilst critics of free-market capitalism argue markets exert too much and power should be in the hands of democratically elected politicians, the assumption policy-makers will exercise this power rationally and in the interests of voters is called into question by behavioural economists. For example, these same critics argue politicians must do more to ensure innocent voters are protected from ‘the markets’ through regulation. However, when it comes to regulation, decisions are influenced heavily by cognitive biases.

Consider the Enron scandal that helped set the stage for Sarbanes-Oxley (SOX). This seems reasonable enough, right? Enron highlighted a number of gaps in regulation – such as auditor conflicts of interest, which were patched up by SOX. However, was SOX the right move? Several observers have questioned the usefulness of SOX, arguing the costs in management time and shift in focus of boards of directors from business guidance to legal compliance have been far greater than expected. However, most people do not perceive the negative impact as the costs of disclosure regulation imposed by SOX upon general shareholders are much less vivid than poignant stories about families ruined by lies and cheating. In addition, the costs of SOX to shareholders is integrated into overall profits and hidden from shareholders.

The case of SOX highlights a common pattern in market regulation. Consider the history of US regulation. The US stock market climbed 200% between 1925 and 1928. In this euphoria, lawmakers passed a law in 1927 allowing commercial banking activities and investment banking activities to combine – as availability bias suggested given no market failures had occurred, the chances of one occurring was low. Then came the 1929 crash. By 1933, the market was down 90%! So the government passed a law separating commercial and investment banks. In the bull market run of the 1990s the market was up 125% between 1996 and 1999. So, the government allowed the commercial and investment activities to combine again in 1999. Following the recent financial crisis, the yo-yo trend is expected to continue, with calls to split up investment and retail banking functions, ensuring no single institution is ‘too big to fail’. The costs and inefficiencies resulting from these availability-bias led regulation moves demonstrate the level of irrationality in policy setting.

At the heart of this behaviour is the overconfidence of policy-makers in their ability to control the markets and identify cause and effect. For example, a correlation between short-selling and market downturns led a number of governments to believe short-selling causes crashes and banning the practise during the recent financial crisis (albeit temporarily). The European Union tried to pin all the blame of the financial crisis on ‘the markets’. First, they said it was the fault of hedge funds (all evidence to the contrary). Then they blamed sovereign wealth funds – although what they had to do with the crisis was a mystery to everyone outside Europe! Perhaps the best example of this type of over-simplified causal analysis came from the former UK Labour cabinet member Hazel Blears, who conjectured as Iceland, which suffered a particularly severe collapse during the financial crisis had only one senior female baker (who quit in 2006), ‘maybe if we had some more women in the boardrooms, we may not have seen as much risk-taking behaviour’. However, markets are a little more complicated than that. As Frederich Hayek once said ‘the economy‘s capital structure is a complex and delicate, one that cannot be mashed and pushed like putty’.

If Government officials really want to understand some of the contributing factors to the financial crisis, perhaps they should look a little closer to home – and the implementation of loose monetary and fiscal policies following 9/11. Unfortunately, another heuristic – self-serving bias – the belief when things go well it is due to our own endeavours, but when things go wrong it is due of external factors, means it is far more likely for politicians to blame the markets and increase regulation than take personal responsibility for the crisis.

For example, the US Treasury Secretary Tim Geithner seemed to go from zero to hero in one day when the stock market soared on 23rd March 2010, apparently because of his latest plan to help banks unload illiquid securities of uncertain worth. The Wall Street Journal headline shouted, ‘Toxic-Asset Plan Sends Stocks Soaring’. However, homebuilder stocks jumped as much as bank stocks, suggesting the same day’s news about a 5.1% jump in existing-home sales deserves much of the credit. Or consider Gordon Brown, the former UK Prime Minister and Chancellor of the Exchequer and perhaps the poster-boy for self-affirming bias – who argued the financial crisis and spiralling UK fiscal debt had absolutely nothing to do with his poor economic policies and failure to save during the ‘good times’, but due to ‘global cash flows’ – or ‘someone else’, in plain English.

Rationalists often argue poor policy decisions are due to the misalignment of politician and voter incentives. But do policy-makers do any better when agency risk is eliminated? In a recent study, three researchers from the University of Jerusalem – Momi Dahan, Tehlia Kogut and Moshe Shalem found economic policymakers who had implemented major policy reforms to pension systems made consistently bad choices when selecting their own pension fund – not only spending less time researching, but being less well-informed than the average lay-person! Behavioural economists suggest the nature of pension decision, which raise unpleasant thoughts such as death and ageing mean people prefer to avoid them. The point is some poor policy decisions cannot be ‘fixed’ just be increasing democratic accountability.

The recent financial crisis left voters up in arms as tax-payers funded bail-outs for fat cat bankers. But what about the cognitive biases which led to the bail-outs costing even more they should have? In a study by Linus Wilson from the University of Louisiana, the cognitive bias of anchoring – the inability to move away from an initial value, was shown to have influenced how much money the Government recouped once the banks were ‘sold’ back to private investors. The researchers found banks that started out offering lower prices in negotiations with the U.S. Treasury to buy back their stock, ultimately paid lower prices. As Wilson states ʻThe U.S. Treasuryʼs apparent susceptibility to anchoring bias could cost U.S. taxpayers hundreds of millions—if not billions—of dollars’.

The common perception of politicians is often split across diverging opinions. One camp view democratically-elected politicians as the protectors of the people, safeguarding the common interest from nefarious capitalist exploitation. The opposing view is one of the capitalist politician selling-out to business and wilfully working with ‘the market’s to screw over the people. However, as the above examples show the reality is not quite so good vs evil and even the well-intentioned can unconsciously be led to act irrationally.

What about the people? When discussing the relationship between democracy and financial markets, the electorate are often depicted as the innocent bystanders – at the mercy of the Davos ʻmasters of the universeʼ. However, the idea markets undermine democracy overlooks one fact – voters often undermine their own interests due to cognitive biases. As the economist Joseph Schumpter wrote in Capitalism, Socialism, and Democracy ʻThus the typical citizen drops down to a lower level of mental performance as soon as he enters the political field. He argues and analyzes in a way which he would readily recognise as infantile within the sphere of his real interests. He becomes a primitive again’.

For example, when assessing politicians, voters suffer from a bias known as ʻaffectʼ – the influence of initial emotional evaluations on decisions. Jack Glaser and Peter Salovey, psychologists from Yale University, describe the political fate of Edmund Muskie as an example of affect in action. Munskie was a dead cert to be the Democratic candidate for the 1978 Presidency elections. However, Muskie did not become President. In fact, Muskie did not even win the candidacy from the Democratic Party. How did Muskie go from hero to zero? By weeping in Public. Senator Muskie, overwhelmed by emotion at a speech in New Hampshire, wept in public – this resulted in an instant reaction, causing voters to develop negative affect and costing Muskie the candidacy. In another study, it was shown political election results were correlated to the number of times a particular candidate was mentioned in the media – the more mentions, the more likely a win. The reality of voting behaviour is ʻfirst impressions countʼ and once initial affect is established actual policies matter very little.

The mix of affect and confirmation bias leads to counter-intuitive patterns of behaviour. Once an affect has formed and we positively associate ourselves to a party or candidate, we do not just ignore negative information, but when confronted with it, it actually strengthens resolve and support. For example, following the aftermath of Hurricane Katrina and the Bush governmentʼs heavily criticised relief effort response, Leaf Van Bowen, a researcher from the University of Colorado found Republicans support for Bush did not decrease, but strongly increased! As one researcher points out ʻIf voters strengthen their support for a preferred candidate even in the face of negative information about that candidate, what is the likely result in an election context? Such voters might well be led astray by their affect, ultimately voting for a suboptimal candidate simply because they start out liking that candidate based on early information.ʼ

If we are irrational in political decision-making, could we also be irrational in the way we evaluate the relationship between markets and democracy? In his book ʻThe myth of the rational voterʼ, the American academic, Bryan Caplan highlights an anti-market bias – a ‘tendency to underestimate the benefits of the market mechanism’. According to Caplan, the populace tend to view themselves as victims of the market, rather than participants of it.

This perception of victimisation is fuelled by availability bias – as events with a compelling and emotionally charged story are more easily believed. So when, in his first inaugural address in 1933, Franklin D. Roosevelt attacked ‘unscrupulous money changers,’ and called for ‘…two safeguards against a return of the evils of the old order; there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people’s money…’ this resonated with voters. This attack on financial intermediaries is nothing new. Aristotle argued money was ʻbarrenʼ (it does not reproduce like an animal or crop) and Shakespeareʼs Shylock immortalised the perception of the villainous financial intermediary, ready to claim his ʻpound of fleshʼ.

Moralistic interpretation feels good as it provides a satisfying narrative. Conspiracy theories provide simple, easily understood explanations, and allow the adopter of such theories to feel perceptive and special. Unfortunately just because they feel good, does not make them right.

The truth is, there is a villain in this story. However, it is not the ‘masters of the universe’ investors who undermine democracy – far from being the seductive mistress who ended the happy marriage between voters and politicians, markets create positive side-effects and increase the checks and balances to which political actors are held to account. Nor is the villain of this piece sycophant politicians who will do anything to stay in power – even sell-out the voters who elected them.

Our deep desire to understand causality and find meaning makes it easier to see the hubris of investors and ineptness or corruption of politicians as this enables us to apportion blame and because if we understand why, we can control the how.

The truth is, the real villain of this piece is human nature, or more specifically, human nature’s ultimate frailty – the propensity to control. We live in a complex world where causality is difficult to understand. However, no-one wants to hire the trader who is not certain she knows where the FTSE 100 will be trading at the end of the year, or vote in the politician who is not absolutely certain he knows how to fix the fiscal deficit. This control propensity amplifies the desire to prescribe causal links – if you understand what causes something you can control it.

So when it comes to the relationship between markets and democracy, we seem to prefer the illusion of conspiracies and simplistic causality than the reality of a complex world operating outside of our control. In fact, the control propensity is so deep we prefer to believe in politicians and voters who screw us over – because at least then someone is in control and we do not have to confront the uncomfortable and painful reality succinctly described by the Greek historian Herodotus: ‘Of all men’s miseries the bitterest is this: to know so much and to have control over nothing.’

Written by Brijesh Malkan

October 19, 2010 at 6:59 pm

Changing Perfections: Where do we go from here?

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Most of us hate change.

It is hard, often painful and seldom simple. Whether it be at an individual or organisational level, change forces us to confront an ugly truth, one most of us would prefer to overlook – that we are not perfect and there is ‘room for improvement’.

Whilst this uncomfortable truth makes change difficult for most, it is an especially acute challenge for religious institutions – organisations founded on eternal and ‘perfect’ truths.

Be it same-sex marriages, female priests or birth control, calls for religious institutions to change practises and doctrines held sacred for millennia, are manifold – and ISKCON is no different. Recently, the GBC offered their ‘thoughts’ on homosexuality, debate over whether same-sex blessings should take place in temples have begun to spread across the Internet, and commentators are beginning to openly discuss changing attitudes on sex.

However, the challenge in essence, is no different to the one faced by other organisations and individuals – what changes should be accepted, and which rejected. And in this regard, ISKCON can benefit from the body of knowledge and experiences of other organisations who have successfully implemented change.

Before we move on, it is important to address the fallacy ‘all change should be rejected’. The fact is, changes have taken place within our lineage – be they the initiation of women, changes to regulatory principles and minimum standards or other points of practise. Adaptation has been a constant theme – even the basis of our movement (the Hare Krishna maha-mantra) was adapted to make it accessible to the masses.

The question is not ‘why change?’, but ‘what change?’.

So, how do we decide? Firstly, there must be a reference point – a North Star, to help guide what direction to take.

For corporations this often relates to a mission statement and/or set of values. This guide, like the North Star must be unambiguous, non-transient, clear and succinct. What is ISKCON’s guide? Srila Prabhupada’s books (unedited or otherwise) and words, may hold some answers. However, they do not fully meet the criterion – the sheer volume overrides the succinctness criteria, furthermore, the number of ‘Prabhupada said’ debates that take place demonstrate how difficult it is to derive unambiguous directives. So, what else? The GBC? Putting aside the disconnect between the Governing Body and the general community of devotees, or the perceived lack of credibility, a bigger issue appears to be the inability to provide unambiguous guidance (Is chocolate bona-fide?!). Even the ultimate safety net – ‘Guru, Sadhu and Shastra’ fails to close the debate. Which Guru? Who is Sadhu? And which Shastra?

This lack of agreed and unambiguous reference point (such as ‘self-effulgent’ Guru, or mission statement that can ‘fit on a t-shirt’) creates a dangerous paradigm. Firstly, without a collective focus, each centre, temple, mini-movement or Guru-group can go off on a tangent, claiming to be the true ‘heir’ of Srila Prabhupada’s mission, whilst paying lip service to ISKCON, the institution. Secondly, it can lead to changes being accepted, simply on the basis of the (self-interested or well intentioned) protagonist’s expertise (and status) to argue their case. Without a clearly defined mission how do we decide on strategic direction and which projects to take up? Do we focus limited funds on more Harinamas or building a new Resource Centre? Building Schools or University Preaching? The point is that, whilst there may be no harm in any of the choices we make, without a clear and contextualised aim, we may choose sub-optimal projects, and worse fail to implement or measure projects by the correct goals. At present, it appears we are hedging our bets and have our ‘fingers in many pies’. As Michael Porter, the father of Corporate Strategy, said ‘The company without a strategy is willing to try anything’.

However, until the day the institution addresses the issue the best advice can be found in The Serenity Prayer, and the words of Mahatma Gandhi – rather than trying to reform the institution, one must heal thyself and ‘be the change’.

Written by Brijesh Malkan

October 7, 2010 at 8:43 pm

Posted in Uncategorized

Behavioural Economics Rulez, Ok?

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If you needed further evidence behavioural economics is beginning to dominate the intellectual playing field, you need look no further than last weekend’s Financial Times, where you will find a short (but salient) piece by the FT’s Managing Editor, Robert Shrimsley, criticising the field. Yes, that’s right – criticising behavioural economics.

Mahatma Gandhi once famously said ‘First they ignore you, then they ridicule you, then they fight you, then you win.’. Schopenhauer (yes, that German bloke with the cat) argued ‘All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident’. Shrimsley’s piece, full of ridicule and opposition, reflects the sea-change taking place within the establishment’s psyche – the understanding that human beings do not mirror the fully rational, profit-maximising, self-interested ‘homo-economicus’ of neo-classical theory, is firmly on it’s way to becoming self-evident truth.

Supporters of the ‘irrational’ field will argue recent moves by the Obama and Cameron administrations to introduce recommendations from behavioural economics into policy decisions, serve as a better illustration of growing acceptance and influence. However, critiques use the same examples to highlight the ineffectuality of the discipline – relevant only where ‘hot air’ theorising and pontificating think-tanks are the norm.

Although this criticism may be unfair, the fact is, despite the first major findings within behavioural economics being made nearly 30 years ago, the field has failed to live up to the hype or expectations – other than perhaps through book sales (as Shrimsley is quick to point out).

Perhaps, these shortcomings are no more evident than in behavioural finance – the intersection of behavioural theory and investment management. For decades, researchers have demonstrated irrational investment decision-making by consumers, professional investors and regulators, and the recent financial crisis has spawned hundreds of new academic papers ‘explaining’ the crisis through a ‘behavioural’ lens. However, whilst behavioural economists are quick to ‘explain’ why things go wrong, investment management is still dominated by the Efficient Market Hypothesis (EMH) and Capital Asset Pricing Model (CAPM) – theories based upon neo-classical rationalism. The inability of behavioural economists to offer functional, applicable and concise replacement models is seen as it’s greatest failing – behavioural economics is great in theory, but useless in practise.

However, this criticism misses the point of what behavioural economics is (and is not). Whilst it is human nature to take sides and reduce complexity to simplistic paradigms, such as good vs evil (or rational vs irrational), behavioural economics is not (and was never conceived to be) the antithesis of neo-classical theory. Daniel Kahnenman, the nobel-prize winning father of behavioural economics views his findings as ‘deviations from the standard model’, not an outright replacement for rational choice – behavioural economics was never meant to replace neo-classical theories, but enrich them.

Furthermore, the application of behavioural models has (and continues) to provide valuable contributions across a number of areas. Climate change policy is benefiting from the implementation recommendations to reduce energy usage, and hedge funds (who never do anything unless there is money in it for them) have begun to implement behavioural models within the investment decision-making process.

The monopoly of ‘homo-economicus’ had ended, but not in the way we think. Human beings are complicated and conflicted, neither fully rational nor irrational, and both rational and irrational theories and tools must be used in conjunction to deliver value and insights. It will take a little while to adjust to this brave new world. But as Schopenhauer and Gandhi suggest, all the signs show we are making progress.

As for Shrimsley’s article? An out of context and sensationalist piece, by a journalist well known for his satirical musings? It does not take a behavioural economist to see what’s going on there…

Written by Brijesh Malkan

October 4, 2010 at 10:39 am

Why five referees may be worse than one.

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This week’s European fixtures drew almost as much media attention due to the men standing pitch-side, as those playing. This week’s fixtures witnessed the introduction of new UEFA measures to improve officiating and decision making – the introduction of goal-line officials.

UEFA have acted to address criticism, enhancing focus where it matters – in the penalty box, adding two new officials on each goal-line, bringing the total number of officials to five (1 referee, 2 touch-line officials, the 4th official and 2 new goal-line officials). The implicit rationale is more is better and as referees cannot be expected to be every where or see every event on the pitch, increasing the number of officials will enhance officiating and improve decisions.

Unfortunately, whilst the idea may be sound in principal, research from the field of social psychology challenges the notion – suggesting more officials may degrade, not improve decision making.

Two American psychologists – John Darley and Bibb Latane, carried out a series of classic experiments in the 1960‘s to determine how decision-making is affected by the number of people involved. The experiments were influenced by the rape and violent murder of Kitty Genovese in New York, which was witnessed by a number of bystanders – all of whom failed to assist Ms Genovese. The incident was highly publicised in the mass media and was reported as a damning indictment of modern society. Darley and Latane felt the reason no-one helped Genovese may not necessarily be due to declining moral standards, but due to a quirk in human decision making under pressure to reach a rapid conclusion. To investigate their hypothesis, the academics set-up a number of staged events in public places. These events involved a ‘stooge’ suffering from an emergency such as a seizure or injury, and seeing how members of the public reacted. The results were surprising – the chances of the stooge receiving help was not related to the seriousness of the ailment, how much effort was required or whether the perceived any personal risk. Darley and Latane found the number of witnesses was the key differentiator – the more witnesses (or bystanders), the LESS likely the emergency-stricken stooge would be to receive help. The effect was far from trivial – when one person witnessed the seizure, there was an 85% assistance rate. This rate dropped to 30% with just five witnesses present!

Since Darley and Latane’s experiments, a number of further studies have consistently demonstrated the same phenomenon – known as bystander effect – in situations where rapid decision-making is required (such as someone suffering a seizure or determining whether a penalty-box tackle was clean or a foul), the more active witnesses (those in a position to make a decision), the lower likelihood of positive action.

Why would this phenomenon be so prevalent? The answer lies in the need for a rapid decision and response. Behavioural psychologists explain when faced with a situation requiring a quick decision, where time to fully analyse a situation is unavailable, we tend to defer to ‘shortcuts’ or cognitive ‘rules of thumb’ to make a decision. These shortcuts (known as heuristics) provide an effective mechanism to make a rapid judgement, but like any rule of thumb, they are not always accurate, and can lead to flawed decision making. One such shortcut is to ‘follow the crowd’, the assumption is when people all act in the same way, they must have a good (rational) reason for doing so, and therefore this behaviour can be safely emulated. By following the crowd we can ‘free-ride’ on the rational analysis of others to make a quick decision. Sometimes this type of decision-making results in good outcomes – for example, going to watch a movie ranked highly in the charts or buying a ‘popular’ car can be the ‘good’ decision.

However, there are two problems with this approach. Firstly, in sequential decisions (where we make a decision after others), basing our action on the assumption those who preceded us made a rational analysis in choosing a movie or car, or even that their tastes and needs align with ours, can lead to poor choices. Secondly, when multiple people are expected to make a decision in real-time, each decision-maker looks to others for a signal on how to respond, and our innate reluctance to stand out from the crowd means there is danger of ‘paralysis by observation’ – as we all look to one another for signs on how to react, and collectively do nothing. In the sad case of Kitty Genovese, researchers have argued the bystanders were not selfish or uncaring – there was just too many of them, and due to each of them looking to the other for a social cue on how to respond, they ended up doing nothing. As time went by this silence bound each of them with greater and greater force.

So why may one referee be better than five? With multiple officials, any single official may be reluctant to stand out from the crowd and make a unilateral decision (such as call a penalty or offside). For example, in the Spurs vs Tvente game this week – goal-line officials failed to call Goalkeeper movement during a penalty kick, possibly due to the fact no other official reacted to the offence.

A single referee may make mistakes, however as he (or she) has exclusive responsibility for officiating, they are more likely to take an action – rightly or wrongly. The fact is, due to the way in which we make decisions, simply increasing the number of officials does not guarantee an improvement in decision-making, and can have a counter effect to that desired. However, whether a single referee may rely on other shortcuts or socials cues, such as an aggressive capacity crowd, players protesting or feigning injury or simply a dislike of a particular player, well, that is a different story all together. Did someone say ‘goal-line technology’…?

Written by Brijesh Malkan

October 1, 2010 at 7:35 pm

Posted in Uncategorized