Plato vs. Freud

by Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

Have you ever wondered what some of the great thinkers might have thought about our current practices of risk management?  While reading on a topic totally unrelated to risk management (?), namely religion, I came across this wonderful description about how Plato and Freud thought about the ability of humans to reason.  I quote:

“Plato argues that the highest form of human nature is reason, and that reason works to make our passions subservient in order to reach our true end.  Freud, by contrast, argues that reason is not supreme but is the handmaiden of passions.“[1]

Now what made this passage particularly interesting and timely for my tiny brain is that I had just finished Akerlof’s and Shiller’s book “Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism” (Princeton Press, 2009).  In this book, Akerlof and Shiller argue that the “Animal Spirits” of humans often override the assumed rationality of the economic man and thus we get economic events such as the recent economic crisis.

When thinking of these “Animal Spirits” or the passion versus rationality divide in the context of risk we quickly realize that it is a rich avenue for thought and exploration.  We tend to think of risk managers as being rational, controlled and analytical.  Passion is seldom a word that is associated with the risk manager, much less the risk department.  But is a risk manager truly devoid of passion?  Are senior managers devoid of passion when they make judgments about risk?  What about Board Members?  The answer of course (when framed in this blunt way) is that risk managers, mangers, and even Board Members are always making decisions based at least as much on passion or animal spirits as they are reason and rationality.

A follow-up question is to ask whether or not this is a bad thing?  To that I would argue that the question is a moot point, as there is little to nothing that we as risk managers can do about it.  However we do need to be cognizant of it, and incorporate the fact somehow into our analysis and suggestions.  That requires empathy as well as creativity – along with a host of other skills.

In several recent talks (see for example “Beyond Behavioural Finance”) I have argued that risk managers need to think like sociologists.  Perhaps we also need to spend a bit of time boning up on our philosophy.

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[1] Foster, Richard J., and Gayle D. Beebe, 2009, “Longing for God:  Seven Paths of Christian Devotion”, IVP Books, Downers Grove, IL

Time for Sociology

by Rick Nason PhD, CFA
Partner, RSD Solutions Inc.

As I believe I have stated before, I am a product of a science background within the context of a liberal arts degree.  That background is a bit of a rarity in the current world of specialization and hard core finance education.  (Count all the different programs offered worldwide in quantitative finance and financial engineering.)  However it is a background that I believe provides a unique advantage in many different situations.

One of the advantages is in the area of the social sciences.  Very few finance practitioners these days have much more than a passing acquaintance with the social sciences – if that.  That just might be the biggest weakness in finance and risk management at the moment – not regulation, not an over-reliance on mathematics, not greed, not any of the suggestions that the popular media is firing at finance and risk management these days – it simply could be the almost total lack of appreciation for the social sciences.

More than anything, risk management is about people management.  Furthermore it is people management not only in the context of one on one (which is important), but also people management in the context of a crowd – which is a very different thing.

Some of you are probably saying at this point that Nason has obviously been in a cave for the last two decades as behavioural finance is now such a big topic – especially amongst academics.  Leaving the topic of the relevance of finance academics alone for the moment, I would like to defend myself by stating that I am well aware of behavioural finance.  (In fact I gave a day long pre-conference on the topic at the Canadian Derivatives Conference a few years ago.)  Behavioural finance however is not what I call sociological finance, and behavioural finance is missing a lot of the point.

What’s the difference between behavioural finance and sociological finance?  Good question – and to be honest one that I have a better intuitive feel for than a finely worded explanation for.  Behavioural finance – as it has, and is being currently studied and researched - is focused on how the individual behaves.  In other words it is how an individual makes financial decisions, and how those decisions are often more irrational than we as academics and modelers would like them to be.  That is all fine and good, and it shows why our quantitative models may give inaccurate results.  However it does not go nearly far enough.

Sociological finance is studying how a group of people makes decisions.  That is very different from how an individual makes decisions, and is even different from how an individual makes a decision within the context of a crowd which is the bailiwick of behavioural finance.

A group of people, or a crowd if you will, is a very different entity from the summation of a group of individuals.  In other words, understanding how five people will make decisions frequently tells you little to nothing about how they will collectively make decisions.  Put yet another way, summing the decisions of the five tells you nothing about how the group as a whole makes a decision.  Sociology differs from psychology in that decisions of individuals are not summable (I think I violated the English language on that one – thank goodness blogs are allowed to be informal.)

Crowds are not the sum of the people that make up the crowd.  Crowds evolve differently from how individuals evolve.  The study of complexity has shown us that crowds are an emergent system.  Psychology does not necessarily apply.

Now the question to ask is are most risk and finance events the function of an individual or a crowd?  For specific risk events the answer is that frequently it is the function of an individual.  For finance and market related events, reflection will likely lead one to realize that it is the crowd that is the driving factor, not the sum of individual actions.

Thus the study of sociology is key to understanding systematic events, not psychology and behavioural finance.

By the way, this blog has been sponsored by my sister, a sociology professor who needs more students in her classes

I Really Planned On Being A Crook – Not!

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

A few years ago RSD Solutions did a training session for a group composed of members of the front and back office operations of a multi-national bank.  The session was focused on ethics, and more particularly ethical debacles in the context of breakdowns between oversight between the front and back offices.  Needless to say the dynamics of the group was interesting.

As part of the session we did an examination of many of the well known trading debacles that had occurred up to that time – Barings, Soc. Gen. etc.  We examined roughly two dozen such situations.  It was a fascinating exercise.

One of our conclusions was that after examining all of the available public evidence, (we did not interview any of the related parties, nor did we seek out non-public information), was that each of the debacles and supposed ethical breaches started off really small.  In many, if not most cases, these debacles started with a small mistake.  That’s right, a mistake, and not a deliberate “testing” of the system to see how far it could be stretched (or skewed, or gamed).

In other words, our central conclusion was that most debacles were not necessarily a deliberate ethical attack or ethical breach, but instead something that happened quite unintentionally. 

A second conclusion was that each of these mistakes grew to a debacle for two reasons.  (1) the central individuals involved did not believe that a mistake would be tolerated, and (2) in order to cover up or correct their mistake they then (and only then) undertook actions that they knew were definitely not kosher.  Inevitably things snowballed from there.

We currently hear so much bemoaning the lack of ethics in the markets and in risk management.  The debacles of our time are always being brought forth.  The general population quite naturally assumes that everyone involved in finance is a crook.  I do not think that is true.  I believe (perhaps being very naive) that most individuals in finance are ethical and desire to be so on a continuous basis.

Perhaps it is time to think a bit more carefully before we put systems in place to curb ethical breaches.  Perhaps, counter-intuitively, fewer systems would be more appropriate!   Perhaps it is time for more faith in our fellow workers, rather than less faith.  Perhaps it is time to allow for more mistakes and more forgiveness, rather than less tolerance and less ability to accept mistakes in the context of which they were made.

Perhaps it is time to think, show empathy and understand in context, rather than systemize everything in the sake of rules, regulations and ethics.

Ethical Leadership

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

The new Dean at my university (Dalhousie University in Halifax, Canada) is Peggy Cunningham.  We are all very excited about having Dr. Cunningham lead us as we build on some very exciting projects and some new themes in the Faculty of Management at Dalhousie.

One of the most exciting themes is that of Ethical Leadership.  Now if you are like me you probably rolled your eyes when you read that line about “ethical leadership”.  “Here we go”, you are thinking, “another school that is going to hop on the bandwagon by teaching students right from wrong!” 

Dr. Cunningham (Peggy as she likes to be called) is too smart and more importantly too wise for that.  Like me (see my previous blogs) I suspect she believes that right from wrong is not something that can be taught to someone who is past 6 years of age (although I have not discussed this specific point with her.)

Ethical leadership for Dr. Cunningham is leadership with (a) respect, (b) courage, and (c) empathy.  To me that is a very refreshing and encouraging way of looking at ethics and ethical leadership.

Let’s quickly examine this definition of ethical leadership in the context of the ethical issue of the day – namely Goldman Sachs and the Senate review that occurred recently.  Most of you have read the transcripts or seen part of the testimony of the Goldman executives before the review committee.  Probably more of you spent time trolling the various joke sites and e-mails making light of the hearings.

In any case, let’s examine these hearings in terms of ethical leadership.  Who was showing respect?  Was there any respect in any part of the incident (the Abacus transaction, or the review hearings)?  Was there respect shown by those who made fun of the hearings?  (In the interest of full disclosure I am certainly chuckling at the jokes that are still circulating around.)  Was there respect shown by either the executives of Goldman Sachs or by members of the review committee or by the various protesting groups?  Was there respect shown by the counterparties to the original transaction?

Who has demonstrated courage in this whole affair?  Is it the SEC who brought the charges (although we understand there was significant debate about whether or not they should, and there are suspicions that the charges may be politically motivated)?  Who is being courageous? 

Who has demonstrated empathy?  Surely to goodness you are not going to reply the Senate committee members as they empathize with the counterparties who lost on the transaction (the same counterparties that they would have been praising for being courageous for helping to grease the housing boom, or courageous for taking risks to finance profits etc. etc.).

The world of risk management is rife with opportunities where ethical leadership is called for. Think about situations that you have been involved in.  Are you demonstrating “ethical leadership”?  Are the principles of leadership with (a) respect, (b) courage and (c) empathy part of the social fabric of your organization?  Are they part of your personal make-up?

In an earlier blog I stated quite emphatically that I do not believe that ethics (teaching of right from wrong) can be taught to anyone over the age of six.  What I do believe is that ethical leadership can be inspired in people.  I also believe that most of us want to be inspired to be ethical leaders.  In this age of the cynical sound bite, ethical leadership just might become the new black.  I hope so.

Can Ethics Be Taught?

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.
 

As a Business School Professor I am constantly being asked to incorporate ethics training into my classes.  I refuse on the simple premise that to do so would be to teach the stupid people how to cheat!  I suppose I should explain.

The cry for the teaching of ethics in business school originates in the assumed lack of ethics in business – and more specifically a lack of ethics in finance.  As I will explain in several later blogs, I do not believe that finance people are any more or less unethical than the general population (more competitive yes, but being competitive is not necessarily unethical).

Ethics in business school has become the strict teaching of right from wrong rather than the more traditional academic examination of moral dilemmas.  Teaching people right from wrong is a fool’s errand in business school.  First off, by the time that someone has reached business school they already know right from wrong.  Furthermore, a person’s desire to act ethically has probably already been set by the time they begin elementary school, much less when they are twenty-something year’s old.

The next time you see a major ethical breach, ask yourself these questions:  (1) Did that person know what they were doing was wrong?  The answer is always going to be yes.  Ethical breaches in finance are only extremely rarely a case of moral ambiguity.  (2)  Would the perpetrator of the ethical breach have undertaken their actions if they knew that they were going to be caught?  The answer is always going to be no. 

Thus the teaching of ethics is not going to stop any of the breaches that we observe in the market.  Ethical people will always strive to behave ethically, and unethical people will always be finding ways to shortcut and cheat the system.

Now, the cry for the teaching of ethics in business schools generally comes down to developing case studies on what people did wrong in the past.  In my opinion this is just stupid.  If all we focus on is how to cheat the system, then all we are doing is teaching the stupid people (who are more likely to behave unethically) how to cheat the system.  In other words, ethical courses in b-school might very well be counterproductive.

Let’s focus on creating cultures of Ethical Leadership (see May 21, 2010 blog); recruiting for characteristics of Ethical Leadership and the rest will take care of itself.  Oh – and by the way – by doing so you will be prevented from hiring stupid people!

After Goldman, CBOE is Next

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

It’s tax time in Canada, so combined with the end of University classes I have not had a lot of time to get into the juicy details of the Goldman affair.  However from my admittedly relatively naïve (or is it ignorant) position, it appears like we may have to lock up 99.9% of the financial trading industry (as well as the real estate industry, the used car industry, etc., etc.)  As academics we should throw out any development that we are doing on heterogeneous models.  (As academics that will not be a great loss since we are relatively crappy at developing useful models where everyone is not rational in exactly the same way.)

The Goldman affair – in the context of my very small and simple brain – is about a financial institution having two different sets of clients, who just happen to have different views on the future price direction of a set of assets.  Goldman – more or less acting as a broker – facilitated the trades between the two sets of trading firms.  The shame!  The horror!  The two-faced greedy pigs!  Imagine, facilitating a trade between two parties?! 

My sarcasm would be totally misplaced if the two counterparties (and Goldman itself) were small retail clients or entities.  But they are not!  They are well known and supposedly big institutions with supposedly big brains.  But there is the rub.  Those of us who have worked in the industry know that not everyone has the mental capabilities that they like to think they do – or more accurately try to project to the world that they do.  It is no big secret that lots of people in the financial industry (and almost every other occupation of life) try to pretend that they know a lot more, and understand a lot more than they actually do.  In the interests of full disclosure, academics are no better and probably even worse when it comes to the faking competence game (that is for a later blog).

So here we have these Senate hearings and all of the cries about how Goldman was so unethical about being on both sides of this trade.  That’s their fricking role in the economy!   A trading firm facilitates trade.  Trading is not a win-win proposition, except for the brokers who facilitate trades.  In almost any type of transaction, one party will do better than the counterparty, while the facilitator will make a profit from both.

The real ethics breach in this case is the supposedly knowledgeable institutional investors who entered into this trade without fully understanding what they are doing.  The markets and the regulators have always made a clear distinction between retail and institutional investors.  It is clearly understood by all that the required degree of hand-holding is very different for each group.  The especially greedy ones in this case is not necessarily Goldman (although I suspect they were not averse to pumping their profits to the max from both sides) but the two sets of counterparties.  I say hurrah to all of this greed.  Greed makes the economy works.  What makes the economy slow down is stupidity, and what makes the economy stall is trying to hide behind your mother’s skirt when you do something stupid.  Blaming the other person for your mistakes is the real breach of integrity, responsibility and ethics.  Having the government do the blaming for you is just despicable.

Back to the Chicago Board Options Exchange.  Can you imagine the gall of that institution?  The lack of integrity and ethics of this institution is just disgusting!  Imagine – they offer up for trading both calls and puts!!!!  Think of the moral decay that allows them to offer products to those who think the price of an asset is going up, while simultaneously offering products to those who think prices are going down.  Furthermore these products are offered to retail investors who need to pass a relatively low barrier of knowledge to trade these “exotic” instruments.  How do the employees and members of the CBOE live with themselves?  The CBOE’s Senate hearings will be especially packed with protestors, and I trust the grilling from the Senators will be especially fierce.

Beyond the Bull

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

I just finished reading “Beyond the Bull” by Ken Norquay (BPS Books, 2008).  In this very refreshing look at investing, Norquay, a CMT and Director and Chief Market Strategist at CastleMoore Inc. puts forward a five step financial investment development program that draws on an eclectic mix of the practicalities of the market, psychology, warfare and even Buddhist practices. 

From my previous sentence you might believe that this is a new-age California book that recommends some weird investment philosophy based on magic crystals or mood rings or some similar useless crap.  However your belief would be incorrect.  Norquay, an experienced and successful investment professional, understands that the market has more concrete elements to it than that.  Additionally he also understands that there are more than the objective components to successful investing.  That brings us to the major contribution of this book which is outlining a path or strategy for balancing the various subjective and objective components that comprise successful investing.  (The author breaks this up into a four component model that has intellectual, emotional and instinctive components which are subjective combined with an objective component.)

One aspect of the book that I would particularly like to pick up is the author’s suggestion to “Try to feel the economy as well as think about it”.  All too often as investors (or risk managers) we tend to focus on one aspect (feeling versus thinking) to the exclusion of the other.  Fortunately for those of us who like a challenge, the financial markets reward those of us who like to be diversified in our approach to risk and financial management.  Beyond the Bull succeeds in providing investors a realistic and practical guide to developing the awareness and skills necessary to appropriately incorporate both feeling and thinking into investing.

This book will be of interest to retail investors, and the salespeople who service them.  Unfortunately few salespeople are likely to get past the first few chapters as Norquay convincingly lays bare the weaknesses of the traditional “sales bull”.  I would appreciate seeing a follow-up book to this that is geared more to the institutional money manager, as I believe the approaches presented in this book will also work at the more advanced level.

When I received this book I was expecting a traditional charting based book, or a take on the now well worn behavioral finance path.  The refreshing aspect of Beyond the Bull is that it takes a different path that is truly “beyond the bull” that is so prevalent in the how to invest genre.