Earlier this month, on two separate days, the gold price fell the most it has in 30 years. Neither drop had solid foundations. Commentators have come up with a range of esoteric explanations as to why the metal sold off so sharply, but none of them holds much water. Gold is traditionally a haven when things elsewhere are going wrong, but the gold price fell at the same time as the S&P 500, the leading US share index, and the yields on 10-year US Treasury bonds.
It is hard to escape the conclusion that gold investors sold off because other investors were selling – in other words, herd instinct kicked in. Until economists and regulators are able to incorporate into their models and rules the fact that human beings behave in such ways, our understanding of the financial crisis – and our ability to avoid another one – will remain limited.
Fortunately, many authorities, driven to tighten up inadequate supervisory regimes in the wake of the crisis, are trying to include more behavioural economics in their oversight. In the UK the newly minted Financial Conduct Authority (single objective: protecting and enhancing confidence in the UK financial system) has committed to analysing how people behave in order for it to intervene in markets “more effectively, and in new ways”. The FCA’s chief executive, Martin Wheatley, believes that behavioural economics will help it to assess potential problems better and to choose more appropriate remedies.
The problems the FCA has chosen to focus on are not – so far at least – of the order of what brought down Lehman Brothers or Long Term Capital Management. It has chosen to start by looking at some everyday financial services problems in a different way.
Why do consumers behave in ways that are not obviously rational – for example, preferring credit cards with low teaser rates for an initial period, then very high rates and charges after that? The regulator has already drawn on behavioural research to provide sensible advice on how businesses can write letters so that their customers will actually read them (putting bullet points at the top of the letter and cutting the waffle).
But this change suggests a radically different approach by a post-crisis regulator to understanding consumer and corporate behaviour; one that tries to include in its assessments the fact that human beings do not make choices in a calculated way.
However, incorporating these insights will be fraught with difficulties. As the FCA itself admits, designing and implementing “behaviourally informed remedies” is not only new, it will require extensive testing and research.
There is a bigger obstacle. It feels intuitively right that we should be analysing the way people behave in order to help us understand why financial markets do what they do. But this may have less to do with behavioural choices and more to do with the personalities that choose to operate in them.
There is a compelling body of evidence suggesting that the people most likely to go into the riskier areas of financial services are precisely those least suited to judging risk. Susan Cain’s recently published book Quiet cites a series of studies that suggest that extroverts tend to be attracted to the high-reward environments of investment banking, deals and trading. And, troublingly, these outgoing people also tend to be less effective at balancing opportunity and risk than some of their more introverted peers.
Ms Cain tells the story of Vincent Kaminski to show what can happen to a business when aggressive risk-takers enjoy too high a status relative to more cautious introverts. Mr Kaminski served as managing director of research for Enron, the energy company that filed for bankruptcy in 2001. In that role, he repeatedly tried to sound the alarm about the company entering into business deals that, he thought, threatened its survival. When his superiors would not listen, he refused to sign off on these transactions. The consequence? He was stripped of his power to review company-wide deals.
As the financial crisis began to flower in 2007, Mr Kaminski was interviewed by the Washington Post. He warned that the “demons of Enron” had not been exorcised. In particular, he complained that many who understood the risks that the US banks were taking were ignored because of their personality style. He said: “The problem is that, on one side, you have a rainmaker who is making lots of money for the company and is treated like a superstar, and on the other side you have an introverted nerd. So who do you think wins?”
Recent research, according to Ms Cain, suggests that there may even be an “extrovert gene” – one that regulates production of the hormone dopamine – which is associated with a particularly thrill-seeking version of extroversion and is a strong predictor of financial risk-taking.
At the annual meeting of his Berkshire Hathaway investment vehicle 15 years ago, Warren Buffett said that success in business does not depend on IQ. “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
It has often been suggested, since the crisis, that what financial markets need is less testosterone. In fact, perhaps it is less dopamine.
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