Strategic Framing

There is an excellent article at skeptic.com that ties in to my previous post about how cognitive biases contributed to the Madoff investment fraud.

Stephen Greenspan, author of the new book Annals of Gullibility, describes how he was taken in by Madoff.  He describes four factors which contribute to gullible action: situation, cognition, personality, and emotion.

The article is a wonderful read and nicely links these four factors to the author’s personal Madoff experience.  I’ve spent much time focusing on the connections between cognition and situation and enjoyed Greenspan’s discussion of the important roles of personality and emotion.  His arguments are persuasive and have inspired me to dig deeper into the research on the emotional factors.

I’ve also been inspired to buy his book so I guess I am one data point to demonstrate the effectiveness of articles as marketing for books.

Well played Mr. Greenspan!

One aspect of international travel that I truly enjoy is reading about the business world from a different perspective.  On my trip to Sydney, Australia earlier this month, I dug through local papers and The Australian Financial Review to get a sense of how the current economic challenges where being felt and understood in Australia.  I look forward to getting a different perspective next month when I head to South Africa.

I found in interesting article in an insert magazine in The Financial Review.  The insert magazine is rather amusingly called Boss.  In the article, Mike Hanley did a wonderful job explaining the limits of the efficient markets logic.  A key limitation is that markets consist of human beings and human perception of risk is predictably irrational.  These pervasive cognitive biases were revealed in the research of Nobel Prize winners Daniel Kahneman and Amos Tversky.  Kahneman and Tversky demonstrated how we can be easily manipulated to become risk-seeking or risk-averse, how we over value confirming data and discount disconfirming data, and how we are overconfident in our knowledge and decisions.

I find it interesting to consider the implications of Kahneman and Tversky’s work for the financial markets.  Because these biases are so ingrained and pervasive, we cannot rely on the ‘wisdom of the crowd’ to save us.  A majority of the crowd will suffer from these same biases and it is folly to simply hope these biases will counteract each other.  Rather, what is needed is a system designed to offset these human cognitive tendencies.  I certainly do not pretend to have the answer of what that system would look like.  However, it would surely include mechanisms to limit considerations of sunk costs, counteract confirmation biases and reveal limitations of investor information.

No worries eh?

The potential $50 billion loss is mindblowing.  Even if the losses from the Madoff Investment fraud comes in below this number it is still going to be a fraud of historic proportions.

To put it in perspective, the trading scandal that brought SocGen to its knees and rocked the markets in January 2008 was on the order of aproximately $7.1 billion.  If the sky was falling then, what’s falling now? (side note: If you are stressed and need to relax, close your eyes and try to answer that question.  What can be greater than the sky?  The question has a certain perverse zen like quality to it)

Now the conversation turns to the question: Why did so many people not see the warning signs?  We’ve learned that there were signs of something fishy at Madoff Investments.  The biggest one may be the low probability that any firm can continually generate such predictable returns  in variable markets.  Another warning sign was raised about the feasibility of Madoff’s reported investing strategy for a fund of such a size.

No doubt there are many answers to the question of missed warning signs.  Let me add the role of human psychology.  We depend upon social valuation to judge others in complex environments and we seek information that confirms our initial judgments.  Both these cognitive tendencies came into play in this case.

Madoff relied upon his reputation to bring in new investors.  His legitimacy as a financial professional came from his reputation.  His reputation was built up over such a long time that to spend time investigating Madoff’s expertise is easily dismissed as a waste of effort.   To use the political term in vogue these days,Madoff had been vetted and new investors could comfortably accept that.

Combine such strong reputational legitimacy with our natural bias towards confirming evidence and you have a receipe for fraud.  Our overweighting of data that supports our decisions and underweighting of data that disconfirms our decisions is well documented.  This is the same dynamic that causes politically conservative Americans to watch Fox News and politically liberal Americans to read Salon.com.  It is also the dynamic that prompts investors to discount negative analysis of companies in which they have invested.  Investors may claim the analyst is biased, missed a key point, or just doesn’t get it.  It is easy to rationalize why information is useless once you’ve decided the information is useless.  Madoff invested had $17 billion reasons to rationalize away warning signs.  They’d already made the decision to invest in Madoff.  That was the hard decision.  Seeing evidence to reinforce the correctness of that decision after the fact is easy…and natural.

Roch Paryre, Ph.D. describes the challenge of rewarding decision process instead of decision outcome. Excerpt from a talk on strategic thinking and decision making.

Contact us for more information about Dr. Paryre and other DSI speakers.

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Overconfidence can derail a strategic planning process. It can cause smart people to assume they know more than they do. It can lead groups of people to confidently predict a future when the future is uncertain. It can make a strategy a narrowly focused agenda instead of a map of strategic options for thriving in an uncertain environment.

Roch Parayre, Ph.D. gives some famous examples of overconfidence.

A good decision process can greatly improve the quality of decision outcomes. By developing a common decision approach, an organization’s leaders can begin to build a culture of decision quality. When executives adopt a common decision making framework, they begin to use a shared decision process language and are better able to challenge decision processes in use. In the following video, Dr. Paul Schoemaker describes the steps in an effective decision process.