Ethics debate opens CFA conference

Early attendance paid off for those at the CFA Institute’s Annual Conference, as the opening session on Sunday night included insights from A to Z, literally, as Dan Ariely and Jason Zweig shared the stage in Boston.

Ariely, author of Predictably Irrational and the James B. Duke Professor of Behavioral Economics at Duke University shared his insights into human irrationality and its affect on the markets, but he also took financial professionals to task for allowing conflicts of interest to flourish in the industry.

“As long as you have conflicts of interest, you continue to fail, not because you have bad people, but because all people are susceptible,” says Ariely. “The question is: How as an industry are you going to fight this inherent problem of conflict of interest, especially when nobody sees themselves as being influenced by it?”

To illustrate the problem, Ariely asked the audience how they would feel about appearing before a judge who was paid based on the penalties he handed down?

“It’s clearly crazy, right?” he said. “But if you live in the States, you all go to physicians who get paid by what test they send you to, and we all use financial advisors who get paid in the same way. It’s incredible to me that we understand this lesson to some degree, and nevertheless we haven’t really taken it to heart.”

The prevailing approach to managing conflicts of interest has been to promote their disclosure, but Ariely says this is prone to backfiring.

According to Ariely when an advisor offers a client two options and discloses that one will pay him more than the other, two things can happen. Either the client will discount the advisor’s opinion as biased, or worse, the advisor could push harder for the more lucrative product because they have disclosed the conflict.

“Which of these two forces will win?” Ariely asked. “The answer is the amount that the advisor is willing to shape reality overwhelms the amount that people discount [the advice].”

Zweig, personal finance columnist for The Wall Street Journal, pointed out that human nature leads people to blame themselves for misfortunes – such as the mugging victim who says, “I should have known better than to cut through that alley,” for example. This penchant for self-blame allows the individual to avoid a more unbearable truth – that the city they live in is a chaotic mess, and its citizens are prone crime.

Accepting blame was commonly the case in the wake of the dot-com bubble, he suggested, as investors admitted to themselves that they had gotten greedy. Never again, they vowed, and they decided to adopt “rational self interest,” the intellectual bedrock of most financial markets theory.

In 2008, following that logic left many in worse shape. Zweig suggested this time around, investors know it wasn’t their fault their portfolio blew up, and they want revenge.

Ariely says this is perfectly natural, and in fact may lie at the root of human trust relationships. Typically, knowing another person will seek revenge prevents a person from betraying trust. He gives the example of an experiment:

Two people are placed in separate rooms, and Person A is given $10. They are told that they can either leave with the money, or give it to Person B. In the process of that transaction, they are told the money will quadruple to $40. Person B has the option of leaving with the money, or giving half back to Person A.

Ariely says the overwhelming majority of people in the place of Person A opt to make the gift, presumably on the assumption they will double the $10 to $20 when Person B gives half back.

Perhaps more surprisingly, that trust is usually well-placed, and Person B does reciprocate the gift. This flies in the face of “rational self-interest,” which would dictate that Person B simply pockets $40 and walks away. Ariely chalks this up to Person B not wanting to betray Person A.

Human nature tends to be irrational but proves the species to be a lot “nicer” than rational self interest would suggest.

The revenge motivation is on full display lately, as populist politicians call for new taxes and penalties on those who profited from 2008’s meltdown. But Ariely points out that it is best to make such important decisions when the decision-maker is not in an emotional state of mind.

On a practical level for advisors, this may mean leaving the portfolio performance review to the end of a client meeting, as past performance – good or bad – will have an impact on their decision-making process.

Photo courtesy of the CFA Institute .

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