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Dan Ariely offers 3 irrational lessons from the Bernie Madoff scandal

Posted by: Emily McManus

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Dan Ariely, the author of Predictably Irrational, presented a jaw-dropping talk on cheating and dishonesty at TED2009. We’re posting Ariely’s TEDTalk next Tuesday, and we asked him for his thoughts on the Bernie Madoff scandal unfolding now in New York:

The first chapter of the Bernie Madoff fiasco has come to a close, with Madoff pleading guilty to 11 charges of fraud yesterday.

Madoff’s massive Ponzi scheme was horrific on many levels. But while we watch the next phase of the scandal, it’s important to ask: What lessons are we going to learn from this? I can see three lessons that relate to my work studying human irrationality — and in particular, some non-useful lessons we might learn.

One lesson that individuals and foundations are likely to take from the Madoff scandal is that in addition to diversifying their portfolio across several investments (stock, bonds, equity, cash), they also need to diversify their investments among several advisors. While the idea of diversifying among advisors has some merit — and it could reduce the exposure risk of another Madoff scandal — it will also make the task of managing portfolios much more difficult and much less efficient. Imagine that you have $1,000,000, split among four advisors. You will need a whole new level of coordination among them so they can have the right amount of cash, bonds, stocks etc., across all of your assets.

And I think that people will begin to over-diversify across investors. Why? Because when we have one large and salient instance in our minds, it can be so powerful that we overemphasize it. This same effect is very apparent in what we call “the identifiable victim effect,” and it is the reason that we overemphasize the risks of a shark attack, and underestimate the risks of riding a bike without a helmet. In general, what we find when there’s one single vivid event is that people overweight it — we focus on it too much. So that’s the first lesson: We’re going to learn from the Madoff scandal, but we are going to overdo it.

Read the full essay from Dan Ariely — including two more non-useful lessons — after the jump >>

And watch for Dan Ariely’s TEDTalk next Tuesday, March 17.

Dan Ariely will be speaking in New York City on Monday, March 16, on the floor of the New York Stock Exchange. Details here >>

Photo: TED / Asa MathatDan Ariely offers 3 irrational lessons from the Bernie Madoff scandal

The first chapter of the Bernie Madoff fiasco has come to a close, with Madoff pleading guilty to 11 charges of fraud yesterday.

Madoff’s massive Ponzi scheme was horrific on many levels. But while we watch the next phase of the scandal, it’s important to ask: What lessons are we going to learn from this? I can see three lessons that relate to my work studying human irrationality — and in particular, some non-useful lessons we might learn.

One lesson that individuals and foundations are likely to take from the Madoff scandal is that in addition to diversifying their portfolio across several investments (stock, bonds, equity, cash), they also need to diversify their investments among several advisors. While the idea of diversifying among advisors has some merit — and it could reduce the exposure risk of another Madoff scandal — it will also make the task of managing portfolios much more difficult and much less efficient. Imagine that you have $1,000,000, split among four advisors. You will need a whole new level of coordination among them so they can have the right amount of cash, bonds, stocks etc., across all of your assets.

And I think that people will begin to over-diversify across investors. Why? Because when we have one large and salient instance in our minds, it can be so powerful that we overemphasize it. This same effect is very apparent in what we call “the identifiable victim effect,” and it is the reason that we overemphasize the risks of a shark attack, and underestimate the risks of riding a bike without a helmet. In general, what we find when there’s one single vivid event is that people overweight it — we focus on it too much. So that’s the first lesson: We’re going to learn from the Madoff scandal, but we are going to overdo it.

Another non-useful lesson that I think we will adopt is to start searching with more vigor for other bad apples. On one hand, it is clearly important to prevent more Madoffs, but at the same time I worry that as a consequence of searching for bad apples, we won’t pay enough attention to other financial behavior that might not be as badly wrong but that can actually have larger financial consequences.

In our research on dishonesty, we found that when we give people the opportunity to cheat, many of them cheat by a little bit, while very few cheat by a lot. In our experiments, we lost about $100 to the few people who cheated a lot — but lost thousands of dollars to the many people who each cheated by a bit. I suspect that this is a good reflection of cheating in the stock market, where the real financial cost of the egregious cheating by Madoff is actually a tiny fraction of all the “small” cheating carried out by “good” bankers.

The risk here is that if we pay too much attention to chasing bad apples, we might pay too little attention to the situations where the small dishonesties of many people can have large consequences (such as paying slightly higher salaries to cronies, making small changes to financial reports, doctoring documents, being slightly dishonest about mortgage terms), and in the process neglect the real economic source of the trouble we are in.

A third bad lesson that I think people will take from this concerns the way we define acceptable levels of cheating. In a study that may parallel Madoff’s egregious dishonesty, we again gave the participants the opportunity to cheat, while solving a puzzle quiz — but this time we hired an actor. This actor, posing as a fellow participant, stood up at the start of the session and declared that he had solved all the puzzles. Now the question is how his behavior would influence the other participants in the room — the ones who were watching him.

What we found is that when the actor wore a plain T-shirt, which made him part of the student group, cheating increased. On the other hand, when the actor wore a T-shirt of the rivaling university, cheating decreased. What this means is that when someone who is part of our own social group cheats, we find it more acceptable to cheat, but when people who are not part of our social group cheat, we want to distance ourselves from these people and cheat less.

Madoff was part of the financial elite — part of an in-group of our financial leaders. Think of all these people who were in his house, who knew him well. So now, when other people in this circle see him cheating, think about the long-term consequences: Would these other people in this financial industry now be more likely to take the immoral path? It doesn’t have to be another Ponzi scheme. It just means that, now that they have been exposed to this extreme level of dishonesty, they might adopt slightly lower moral scruples. Maybe they will start not letting their clients know exactly what they own and what they don’t own, or change a little bit the interest rate that they’re charging them … I don’t think that those in his circle will necessarily become more Madoff-like people, but I do suspect that they will get a substantial relief from their moral shackles. Sadly, that’s his legacy.

So, Chapter One of the Madoff scandal is over, but I worry that the negative downstream consequences of this experience are just starting …

Comments (17)

  • Alkomaty Alkomat commented on Jun 23 2012

    ok

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  • Akon lee commented on Apr 23 2009

    I was going through the full essay from Dan Ariely — including two more non-useful lessons — after the jump , It’s not a non-useful lesson as i guess. Because some rare information was there. Anyway we can’t estimate a value for a lesson.

  • Kenn Cha commented on Apr 18 2009

    @dan
    No doubt about the valuableness of these lectures, It can be million of dollars. But we can’t trust science at all, still we can’t get answer for all in the world. That’s why people are trusting psychic stuff in around the world.
    But your points are ok, I agreed.

  • wevtewvtwetvt wevttvwtw commented on Apr 7 2009

    Controversy is in trend as reports says that Bernard Lawrence Madoff a wealthy businessman and made a fortune of his wealth which led him to own so many properties but now all of it seems to be nothing anymore.A 1969 Rybovich would be a nice addition to the family toys. A 1969 Rybovich is not a classic car, it’s a boat, and they retail for about $2 million, a classic luxury yacht. Well, the one that was owned by Bernie Madoff was just seized in order to get some cash advances to the people he ripped off. The bulk of his holdings and property are going to be sold in order to raise funds to make some sort of reparations for the $40 billion he ripped off from clients. Still, a lot of people would need some serious cash advances to afford a 1969 Rybovich.

  • Boris Bulkin commented on Mar 20 2009

    Grant, a worthy point. I would however suggest to Brandon, that if one treats investment in the stock market as a gamble, then the results will generally vary to the same degree as a randomly betting money on a horse. Through experience, I’ve found it prudent to gain an understanding of the investment vehicle prior to investing my entire life savings. When I began investing in the stock market, I ‘tested the waters’ by investing small sums that won’t affect me should it vaporize.

    Managed funds, bonds and warrants are the same. I believe it’s necessary to be able to speak the language and understand the implications of investment in any area, otherwise it is exactly as Brandon states, “gambling with their money”.

  • Bill Baxter commented on Mar 21 2009

    “So now, when other people in this circle see him cheating, think about the long-term consequences: Would these other people in this financial industry now be more likely to take the immoral path?”

    In the experiment Dan ran, the cheater was getting away with the cheating. Madoff, on the other hand, has been caught cheating. Dan’s experiments didn’t include a cheater getting caught, so they offer little insight into how Madoff’s in-circle will now behave now. Thus Dan’s 3rd conclusion is complete speculation. Some further experiments to probe how people react after seeing cheaters caught would be worthwhile I think. Such studies could have big implications on how we punish egregious offenders. The conventional wisdom is that making an example of someone like Madoff serves as a deterrent. But perhaps the conventional wisdom is wrong?

    • Jean Balthazar commented on Aug 9 2009

      I agree. In Dan’s experiment, the cheater got away with it. The “applicable” part of this experiment would then say that people from other groups would now cheat less in order to mark their difference… but I’m afraid there’s only one group in the financial world, his group.

      Yes, he got caught. So I would expect that people will now, for a while, avoid frauds of this magnitude, and take better care to hide their own smaller frauds, but that’s about it. He’s an outlet for the abused masses, but I don’t think that the “ordinary frauders” are feeling endangered.

      It’s all about the profit/risk balance, and the profits are still immensely higher than the risks. Billion dollars financial frauders, when they get caught, end up with lower penalties than when ordinary people irregularly park their car.

      Whitout even speaking about frauders, see how the billion dollars bonusses came back shamelessly only a few months after the bail-outs… Somebody said things would “change”?

  • Brandon R Allen commented on Mar 16 2009

    This whole mess that this dirt bag created should give us pause about investing in the stock market. For the majority of “investors”, the stock market is merely gambling with their money. Add to it someone who is trying to blatantly rip you off and it is even more disastrous for investors.

  • Emily McManus commented on Mar 14 2009

    @Grant — you’re dead right. The term “disgraced financier” is not accurate, and I’ll change it (this was my term, not Dan Ariely’s).

  • Grant Robertson commented on Mar 13 2009

    OK, that’s it! I can take it from the regular media but I just can’t stand by while intelligent, thinking individuals refer to Bernie Madoff as a “disgraced financier.” It is not as if someone just depantsed him on the floor of the stock exchange. He is despicable. He is a fraud. He is a con man and a criminal. He is not merely “disgraced.” I have to wonder if people would be using such euphemisms if Mr. Madoff had not come from such a privileged background. Or if he were anything but white.

    This deference to the upper classes and the famous as if they innately deserve better treatment no matter what they do has got to stop.

  • Zane Selvans commented on Mar 13 2009

    Ironically it turns out that the risks of riding a bike without a helmet are, like the risks of shark attack, consistently exaggerated: http://cyclehelmets.org/