Sunday, January 6, 2008

Behavioral Finance – Incentive-cause Bias

This is the third 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.

These behaviors are not all bad, many are good in some way - that is why they survived. In fact, these behaviors served some purpose that helped extend life at some time in the evolutionary process.

3. Incentive-cause Bias
Munger also refers to this as the tendency of the salt salesman to tell you how much salt you need, or hammer-owners to see every problem in nail-like terms.

For an example, look no farther than the recent home mortgage crisis. The goal was to get more liquidity in the housing markets by bundling mortgages and selling them to the financial markets. This created a demand for more loans, so lending agents were given incentives to sell mortgages to anyone and everyone. Because the lender immediately sold the mortgage, the agent was off the hook if the loan defaulted. Consequently, the agent did not try to make a good quality loan.

In other words, there was no incentive for the lending agents to scrutinize the credit risks of the borrowers, but plenty of incentive to turn those mortgages around and get them out the door. The incentive-cause bias is alive and well and has come close to toppling the banking system

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