Wednesday, January 23, 2008

Behavioral Finance - Bias from Reciprocation Tendency

Why is it so hard to not smile back at someone? This is the sixth in a series of posts about common human misjudgments. The series is based on a Charlie Munger speech at the Harvard Law School in 1995.

Why study human behavior in relation to finances?
Recognizing and understanding why people do the things they do, what drives them, and what are innately human tendencies is the first step in overcoming your own self and making sound decisions! We want to make rational, logical decisions, but emotions and irrational tendencies get in the way.

6. Bias from Reciprocation Tendency
Reciprocation is the tendency to want to pay back someone who has done something for you.
Any time someone receives a gift or even a kind gesture, it’s human nature to want to return the favor. It can be very simple. For instance, if an individual smiles at me in the hallway or at the coffee station, I am inclined to return the smile. In fact, it is very difficult to not smile back. It’s like they have extended themselves and no matter how lousy I might feel, I feel obligated to acknowledge their effort.

It’s a wonderful human trait to want to give back a favor, but it can also result in unfavorable business decisions. Charlie gives the example of Wal-Mart’s Sam Walton. Sam Walton would not let a purchasing agent take a handkerchief from a salesman, because he knew how powerful the subconscious reciprocation tendency can be. Taking anything from a salesman, could influence the buyer to direct a deal to the salesman as a kind of payback. And it’s possible the buyer would not even know that he/she is favoring the agent.

It may seem ridiculously militant to restrict small gifts, after all it’s just a handkerchief, right? But even when the gifts are restricted to a low monetary value, I have seen an incredible response from people. Once I gave free T-shirts to every member of a team that I was leading. I enjoyed working with the group, we had been through a lot and I wanted to show them I was grateful for their cooperation and hard work. I also thought it would boost morale for everyone to have team shirts.

Once they got the shirts, attitudes changed. What I didn’t expect is that most people felt obligated to do something in return. I got free cokes, free lunches, donuts, even compliments! I tried to gracefully decline, saying that it was a gift and that I did not expect anything back. I was even more surprised that they gave me favorable treatment at the test site by queuing my work first ahead of other jobs. I gracefully accepted this, as it meant I would be much more likely to meet my schedule!

Yes, these folks were being nice and wanting to show their appreciation, but I did not realize at the time what was also at work behind the scenes - a powerful human behavioral tendency was driving them to return the favor despite my objections. They felt like they had to do something.

As you can imagine, in business relationships as well as personal relationships, it’s very helpful to be aware of this type of tendency. It’s a wonderful human trait to want to give back a favor, but as Sam Walton knew, it can also undermine good, sound business decisions.

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