Risk and Human Nature

I do not blame the Wall Street banker solely for this financial crisis, but I am curious as to why so many banks and traders made transactions based on dubious financial models in sketchy sectors like sub-prime mortgages? Wall Street is full of very motivated, skilled, wealthy, and confident individuals. Maybe this combination was exactly Wall Street's problem?

This question prompted me to rediscover Peter L. Bernstein's excellent book on the history of risk: Against the Gods: The Remarkable Story of Risk. I flipped to the chapter The Strange Case of the Anonymous Stockbroker and found this passage striking:

In 1990 [William] Sharpe, published a paper that analyzed the relationship between changes in wealth and the willingness of investors to own risky assets...Sharpe hypothesized that changes in wealth also influence an investor's aversion to risk...increases in wealth tend to strengthen the appetite for risk while losses tend to weaken it. [pg. 264]

I find this passage intriguing because it reminded me a great deal of an article I needed to read for a business class I took last semester. I can't remember the article's author or title, but it discussed at length McKinsey Consulting's very flawed advice to its client companies on rewarding "performing" and "talented" employees. McKinsey advised these companies to not only let its employees work in the most unfettered environment as possible, but to also reward them with a lot of money even if even if the employee messed up. In consequence, several employees were making loads of money by taking on risky and unfeasible projects. There was even a New York Times article published late last year that described how in 2006 100 employees at Merril Lynch broke the $1 million mark in bonuses even though they were taking on these risky sub-prime schemes.

With this in mind, I then proceeded to read Sharpe's original essay published in 1964 from the Journal of Finance titled, Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk. If you look beyond the math Sharpe's article basically outlines that investor preferences and behavior do influence the price of risk. You can refer to the article here.

And what about the conventional economic theory that rational human beings have "ambiguity aversion" (a term coined by Daniel Ellsberg in 1961) and therefore only make decisions based on the least ambiguous information as possible? Psychologists Amos Tversky (who along with David Kahneman created Prospect Theory) and Craig Fox set up an experiment to test this theory. They found that people do indeed bet on "vague beliefs"; however, they do so only in areas where they feel competent in.

The same NYT article I referred to earlier also questioned whether the Wall Street bonus system could have potentially contributed to the excessively risky behavior of Wall Street traders. Wall Street traders were being frequently rewarded for short term gain.

Did taking on so many risky bets in order to strive for more and more wealth turn out to be Wall Street's Achilles heal? From what I have gathered it is quite possible. I am not saying this is the reason, but it is an interesting theory.

Taking on huge risk based on irrational human behavior and flawed financial models in the quest to get rich quickly did not turn turn out not be a good combination at all. Who would have thought?