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Wednesday 4 May 2011

Disposed to Lose Money

Quizzical Behaviour

Most people think that game show hosts are more knowledgeable and intelligent than the people they ply with their inane questions. Obviously they’re more knowledgeable: they have the answers in front of them, but are they smarter?

Despite the obvious fact that assuming someone is smart because they can read answers off a card without falling over is blatantly absurd, this fairly straightforward observation makes little difference to studies of this behaviour, the tendency to attribute to a person certain fundamental qualities based on nothing more than the situation we find them in. As usual, this is a one way ticket to losing money.

Fundamentally Attributed

This behaviour, known as the fundamental attribution effect, is why we think star CEOs are great businessmen, that investment analysts offer useful investment advice and stockmarket gurus have anything useful to tell us. These types of error are, perhaps, understandable because quite how judgement and luck intermingle in these people and roles is hard to pick apart. Other examples, though, aren’t comprehensible at all.

Take the relative smartness of quiz show hosts and contestants where we know the host knows the answers. Ross, Amabile and Steinmetz made sure of this by allowing the questioner to set the questions. It made no difference as they showed:
“It was found, as predicted, that perceivers fail to make adequate allowance for the biasing effects of these “questioner” and “answerer” roles in judging the participants’’ general knowledge. Questioners, allowed to display their personal store of esoteric knowledge in composing questions, were consistently rated superior to [the answerers], who attempted to answer their questions”.
In fact it wasn’t just third party observers that thought the questioners were cleverer. No, the answerers thought they were as well. Attributing situational circumstance to dispositional ability is endemic.

Queens, Snails, CEOs

To psychologists our ‘disposition’ is the set of our innate qualities – whether we’re smart or smarmy, likeable or loathsome. It’s arguable whether these qualities are really set in stone, but we’ll assume that they are to a reasonable approximation. At any given time, however, our ‘situation’ – the place or circumstance we find ourselves in – is obviously not something we’re born with. Unless we’re the Queen of England, or a snail, or something similar. Bang goes the knighthood …

Anyway, roughly, our dispositions are permanent and our situations temporary and most of us would regard this as a statement of the bleeding obvious. Yet study after study has found that we attribute qualities of disposition to a person derived purely from the situation that they find themselves in. So a CEO is viewed as a leader not because they behave like a leader but because they are a leader. And people obey their orders because they’re a leader, not because they make any sense – especially if they’re the kind of dogmatic leader that brooks no debate.

Celebrity CEOs

Following instructions because we’re told to by someone in a position of authority, no matter how stupid or downright dangerous those orders are, is a common outcome of the disposition effect. Failing to question decisions is the default position and has led to a range of sad results, from doctors chopping off the wrong leg through to ships foundering on perfectly visible sets of rocks to cavalrymen charging towards cannon armed with small, pointy sticks.

The pervasiveness of the fundamental attribution error hints at something deeper in the human psyche, something which reaches back into our ancestry: the wish to be in control of future events. As Hayward, Rindova and Pollock explain it in Believing One’s Press: The Causes and Consequences of CEO Celebrity:
“One of the reasons for this attributional bias is that people make attributions in order to ‘predict the future and control events’. Therefore, they seek to explain such outcomes in terms of stable factors, such as the dispositions of an actor, rather than temporary ones, such as the characteristics of a situation.”
Prediction in a Complex World

It’s a plausible explanation – we want to be able to predict the future and attributing innate skill to leaders is one way of making this possible. There may have been a time when disposition and situation were closely correlated, when skills in fighting and hunting were the primary requisites we looked for in our leaders. Although many chief executives often act upon their animal spirits as though this hasn’t changed much the qualities needed in the leaders of modern corporations are rather less easy to pin down.

So we rate high visibility CEO’s as more likely to deliver outstanding returns. This is a shortcut that means we can avoid the necessity of thinking for ourselves because we believe our fortunes are safe in the hands of these superstars who have clearly become high profile leaders because they’re highly skilled rather than through some impossible to analyse calculus of luck.

Unfortunately, as Malmendier and Tate confirm in Superstar CEOs, corporations with celebrity CEO suffer declining performance. Quite why this should be is a matter of debate but Hayward, Rindova and Pollock suggest that any chief executive who is fĂȘted by the media may come to believe their own publicity, resulting in both excessive and unwarranted overconfidence, a result also supported by yet more reseach from Malmendier and Tate, and an extreme case of commitment bias where the leader refuses to admit a mistake until it’s too late to recover.

Although you might think that a leader’s advisors might offer a route to unpick these problems the psychological research suggests just the opposite. The more dogmatic and determined the leader, the less likely it is that they’ll face any opposition. Leaders who quash dissent are virtually certain to be able to make any decision they feel like virtually unopposed.

Electric Dissent

Stanley Milgram’s famous experiments, which involved participants being encouraged by a researcher to carry on applying electric shocks to someone screaming for them to stop, showed that we’ll do the most remarkable things if someone in authority encourages us to. There are few more dictatorial figures around than an overconfident, committed CEO that believes their own press.

The only real counter to this that Milgram was able to find was dissent among the authority figures. If the researchers started arguing over whether it was OK to continue electrocuting the stooges the rates of compliance amongst the participants dropped to zero.

Of course, the Milgram experiments are just another example of how situation trumps disposition. We may think we wouldn’t apply electric shocks to a screaming, pleading victim at the urgings of an authority figure but the research suggests that we likely would. This behaviour is ingrained, although whether it’s learned or innate is debateable. Either way, it’s something we should learn to control, both in investment situations and those involving the torture of innocent third-parties.

Make Your Own Mistakes

In analysing the statements of company managements we need to apply the same level of scepticism we reserve for sales pitches the world over. If we simply delegate our thought processes to these conflicted third-parties without applying appropriate levels of analysis we should expect what we will likely get.

As is so often the case with behavioural biases, cognitive shortcuts designed to ease our way are, in the hothouse of the world of investing, a disposition to lose money. The danger of the fundamental attribution effect when applied to CEOs or securities analysts or investment gurus or the apparent internet insider with the hot tip is that they’re as mentally hamstrung as we are.

If we have to lose money on the markets we can at least do it through our own errors, rather than at second hand.

Related articles: CEO Pay - Because They're Worth It?, Regret, Investors, You've Been Framed


  1. Reminds me of the gold fund manager hailed as a genius for simply sitting on a load of gold shares over the last ten years as they all went up.

  2. This is so true .I lived threw this at work for years. Thanks for the memories.It was a little easier to stomach once I realized what was going on.