CHAPTEH EIGHT

Fairriess and Ethics in

Decision Mal(irig
You are raduating from a good MBA program. Subsequent to your
"ti g be1- o+finns one or your preferred companies ma lees you an ojfe1, of
w1 la num ' . . bl y l"I ti people }ott
$110 OUO a year stressing that the amount is not negotza e . . ou t rn ie . .
like tlw job. Y oz; lilce the location. However, you find oiit_that the
offeri11g $120,000 to some graduating MBAs from simzlai-quality s . y
accept the ojfe r?
. . l many peoi1le homeless. For
Hurricane Kntrina hits southern Louisi.ana, eav1'.1g . . cl , This
commodities such as building materials, demand ts up and supply zls r.owtn... tlie
. r t crease 11 7Jnces. I! ;ac ' 111 is a condition that leads economists to prec ..ic an m ' . . ..
aftennath of the hurricane, a small building-supply compan:r tlw'.i
prices on many items that in high demand, such as lumbe1 A1 et w p11.ce
ethical? Are they rational?
I d . . b ti ed by the difference
u the first story, many of our stu ents a1e ve1y o ie1 f I J, .. tl. t
between their sala1y offer and the sala1y offers of otl:ers, even I t :ey ea1n tel
l ' difference does not predict how the company vv1ll treat tl1ern m the e.
second story, most people believe that it is not etlneal the corn!J,<1ny
to raise its prices on high-deman<l items. Since many custome1 s cctn be.pi
to negatively to the perceived unfairness of the. price increase, it may .'.10
even be rational for retailers to raise their prices m response to tempoiary
increases in demand, regardless of what economists tell us ought to happen m
efficient markets. d i f
Issues of fairness and ethics are essential to a complete un
decision making. The first half of this chapter focuses on how m i; 1 l'.d s
Jerceive the fairness of the actions of others. As we will discuss,. pe_op e ca1,e
imsionately about fairness despite. the fa<*
1
that

concerns 1s superfluous to our dec1s1011s. rn sec b u l
on ethics considers the ways in which our ethical judgments can e iasec,
usually in self-serving ways, and often withont our awareness.
132
Perceptions of Fairness 133
PEHCEPTIONS 01<' l<'AIRNESS
Research on fairness has focused on either the distribution of scarce resources
(lVIessick, 1991) or the fairness of distribution procedures (Lind & Tyler, 1988)
Most fairness research has avoided making evaluative statements about the
rationality of fairness judgments. This silence has inhibited our understanding
of how our coguitive processes create anger, jealousy, and inefficiency. If we are
to reduce or eliminate our dysfunctional perceptions of fairness, we need to
confront the rationality of fairness perceptions.
Fairness considerations may account for some of the limitations of the
explanat01y power of economic models. Kahneman, Knetsch, and Thaler (1986)
argue that fairness considerations inhibit employers from cutting wages during
periods of high unemployment despite changes in supply and demand, and also
explain particular inflexibility in consumer prices. Here, we examine three
systematic ways in which fairness considerations lead our decisions to deviate
from a rational model. First, we describe situations in which individual judgment
deviates from the expectations of supply-and-demand considerations. Second,
we examine the ultimatum bargaining problem and what it reveals about why
we make choices inconsistent with our own economic self-interest. Third, we
consider how social-comparison processes lead to decisions that may clash with
our underlying preferences. \Ve conclude this section with a discussion of why
fairness judgments matter.
"\'Vhen the Consequences of Supply and Demand Seem Unfair
ln a provocative set of experiments, Kalmeman et al. (1986) demonstrated that
fairness considerations can dominate economically rational choices in decision
making. Consider the action of the hardware store owner in the follmving scenario,
which mirrors one of our opening stories:
A lrnr<lware store has been selling snow shovels for $15. The morning after a large
snowstorm, the store raises the price to $20.
IVould you rate this action as fair or unfair? From au economic perspective,
the price should go up. \
1
Vhen demand increases relative to supply, an increase
in price is the logical consequence. If the store does not increase its prices, there
will be a surplus of people who would buy shovels at the higher price but who
cannot get tliem because they were snatched up by people at the lower price.
Those who want the shovels may have to spend time and energy standing in long
lines before the store opens. Under some circumstances, the imbalance could
result in a seconda1y market in which individuals can re-sell their shovels to
others at higher prices.
Despite the economic rationality of raising the prices of snow shovels,
82 percent of respondents viewed raising the price of suow shovels to be unfair.
And even among the individuals who said it was fair, many would not think it fair
for a hardware store to raise the price of generators after a hurricane, even though
134 Chapter 8: Fairness and Ethics in Decision ll1aking
the logic is the same. Thus, fairness considerations are often inconsisteut with
economic moclcls.
An interesting reversal of the snow-shovel problem emphasizes the impor-
tance of thinking about others' fairness concerns. Assume that you ovvn the
hardware store and have 25 shovels remaining after a blizzard. Should you raise
the price by $5? Even if you are economically rational, the answer may be no. If
you ignore your customers' concerns for fairness, you might encl up raising the
price and collecting an additional $125 on the shovels. However, the loss of future
business from angry customers may cost you more than $125. Providing your
customers with a brieflesson on the laws o' supply and demancl is unlikely to help
your cause. If they think the price increase is unfair, they probably will react
negatively. Thus, businesses that act in an eco11omically rational manner (e.g.,
increasing the price of the shovels) may undeqJerform those that consider norms
of fairness, because customers may punish retailers for the perceivecl unfairness of
an economically rational action.
These facts raise important questions about how people arrive at fairness
judgments. If you are a hardware store trying to set prices for shovels, you need
lo know when price increases will be perceived as unfair. It would be useful to know,
for instance, that fairness judgments seem to be susceptible to the effects of framing
(see Chapter 5). Consider Kalmeman et aL's (1886) following two problems:
Problem A. A company is making a small profit. It is lo2ated in a co!l1!11unity
experiencing a recession with substantial unemployment but no inflation. Many
workers are anxious lo work at the co!11pany. The company decides to decrease wages
and salaries 7 percent this year.
Sixty-two percent of respondents thought the company's behavior was unfair.
Problem B. A company is making a small profit. It is located in a community
experiencing a recession with substantial unemployment and inHation of 12 percent.
Many workers are anxious to work at the company. The company decides to increase
wages and salaries 5 percent this year.
Iu this case, only 22 percent of the participants thought the company's
behavior was unfair. Despite the similar changes in real income, judgments of
fairness were strikingly different. A wage cut was perceived as an unfair loss, while
a nominal gain that does not cover inflation was more acceptable. \Ve seem to hold
certain rules of fair behavior, such as the rule that wages should go up ancl not
down. Thus, when economic conditions change for the worse, it is chfficult for
employers to reduce wages. Our tendency to rely on nominal quantities, known in
the economics literature as the "money illusion," makes Problem B seem fair, even
though it is essentially equivalent to the wage change in Problem A. It is logical lo
think about money in terms of its actual buying power (real dollars), rather than
the arbitrary unit of a dollar (nominal dollars), which changes in value as a result of
inflation. In contrast, our assessments of fairness are largely built around whether
When We Resist "U11fair" Ultimatums 135

of
mtmt1ve social rules. ' ow om
.. Consumers show similar inconsistencies when thinldng about discounts mcl
puce mcreases Consider the ]] {' '
, . o owmg scenanos ram Kalmeman et al. (1986):
Scenario I A shorta r ] j j d c
c t ge ms c eve ope ior a popular model of automobile 'lllcl
us omers must now wait two months for delive1;'. A de1ler ]rs bee11 sell. t,l,
ctrs t ] t . N l ' " mg 1ese
' a is puce. ow t le dealer prices this model at $200 above list price.
Scenario 2 A shorl'l I j I I r
. . . . . 'ge ms c eve opec ior a popular model of automobile, and
customms must now wmt tvm months for delivery. J\ dealer has been selling ti ....
at a discount of $200 b I 1 l . N l 1ese ca1s
e ow is pnce. ow t 1e dealer p1ices this model at list price
. majority of incl_ividuals view the action in the first scenario to be unfair (71
2,yet only a mmonty cons1clcrs the action in ll1e second sce
1
nrio to be

a.ir_(,4 Consumers seem lo grant special status to the mam:facturei:'s

s_lpulce, they do not expect to pay that amount. The list IJrice 1cts 1s a
c1 I 1ca anc 10 i ff ' ' '
I Tor assessments o. airness, such tliat it is unacceptable to exceed
l
that amtlount. l:e_t, there is 110 nonnative basis for the manufacturer's list IJrice
iavmg 11s special value.
" The pat:ern tlrnt emerges is tlrnt individuals are concerned with de Jartures
tro'.11 . the st,1tus quo and that economically justifiable actions will be
as_ unfa.iL vVe seem to rely on list prices and current prices to set a
rtetfereucef fomt against which we assess changes. When prices change inter1Jre-
a ions o uurness are clearly in.fl cl b tl f' '
Cl
. " . ' uence Y 1e raming effects we discussed in
Mpter o. It is harcl to argue tl t ti ] r
N tl 1 rn le resu tmg imrness judgments are rational.
eve1 le ess, managers ought to be c cl b 1
1k 1 . b . oncerne a out t le way their actions 1re
1
e
1
e_ by employees, colleagues, business partners, ancl
.
1
. ei 2004) d?cuments multiple examples in which consumers' emotions,
rn,t

t market forces, decide what is fair: Delta's attempt to char e $2 JCr

ext! a fo1 tickets not purchased on the First Chicago's of} $3
c iaige foi <lomg busmess vvith a human teller, Coke's development of vendin
that change_p1ice based on demancl leveL We could aclcl lo the list th!
'. g bonuses AIG paid to generously compensated bankers in 2009 at the same
as, :ttlwas acceptmg large government bailouts. In each case, there was no
CV! .ence these act1011s v10latecl market pricing. However, most of us sense
ul1twtrvelby were bacl business ideas because most peo1Jle would IJerceive
t iern to e unfair.
WHEN 'WE RESIST "UNFAHl" ULTIMATUMS
Consitler the following situation:
You are_ traveling on an airplane, silting in an aisle seat uext lo an eccentric-looking
woman m the m1cldle seat (Vivian). Next lo her, in the window seat, is a rather formal-
13G Chapter 8: Fairness and Ethics in Decision Making
looking businessperson (Mark). About 30 minutes into the flight, Vivian inlerrupls
you and Mark. She explains that she is quite wealthy, that sLe becomes bored Oil
flights, and that she likes to pass the time by playing games. She then pulls 50 $100
bills out of her wallet and makes the following proposition. "I will give the two of you
this $5,000 provided that you c<m agree Oil hew to split the money. In splitting up tl1e
money, however, I will impose two rules. First, Mark must decide how the $5,000 is
to be split between the two of you. Then, you [the reader] will decide whetl1er lo
accept the split. If you <lo accept, then you and Mark will receive the portion of the
$5,000 based on Mark's allocation. If you <lo not accept the spilt, tlrnn you and Mark
will each receive nothing." Both you and Mark agree to play tl1e game. Mmk thinks
for a moment and tl1en says, "I propose tl1at the $5,000 be split ftS follows: I get $4,900
and you get $100." Now it is up to you: Will you agree to this split?
If you are like most people, you will probably reject this split. Why? Obviously,
rejecting such a deal is inconsistent with traditional notions of economic rational-
ity, because each party would be better off ( +$4,900 for Mark and +$100 for you)
if yon were to accept it. However, you might choose lo reject this offer for a variety
of reasons that lie outside self-interested wealth maximization. Reasons 1or
rejecting tlie $100 include not wantiug to accept an unfair allocation and not
wanting Mark to benefit from your acceptance. Alternatively, some may argue that
yon arc doing society as a whole a favor by punishing Mark for making an unfair
offer. Any of these possibilities show that fairness concerns factor into your
decision. If you were unaffected by fairness considerations, you would accept
the $100. After all, $100 is better than no'.hing. If Vivian had instead offered to
hand you $100, you likely would take it.
This story points out the importance of understanding the role of fairness
and equality in decision making. Assume that the roles were reversed: You
could determine the allocation, and Mark would have the option of accepting or
rejecting it. What would you decide? If you did not factor in fairness consid-
erations, it would be easy to conclude that the other party would accept the
$100 or even less. However, this proposal would very likely leave you with
$0 because Mark would probably reject your offer. In contrast, a consi<leration
of fairness aud emotion would lead you to anticipate the likely response of
the other party and consequently improve the expected value that you would
receive from this transaction by offering the other party significantly more
than $100.
This airplane story may seem to be an implausible and contrived situation, but
we play a game with this un<lerlying structure every day. Any time we consider
buying something at a store with a posted price, we are put in the position of
deciding whether to accept the store's ultimatum offer. The store has chosen a sale
price that is, presumably, above the store's cost. If you value the item more than
what it costs, then you may choose to buy it. But you are not invite<l to negotiate
with the clerk at the grocery store about whether you think the celery is really
worth what the store is charging. The store has given you an ultimatum: "Ilere is
our price. Take it or leave it."
YVhen We Resist "Unfair" Ultimatums 137
. A number of researchers have systematically studied how people respond to
that are similar to the fictitious airplane story (Gi.ith, Schrnittberger, &
Schwarze, 1982). In these studies, a proposer divides a known, fixed sum of money
a'.1y way he chooses.by filling out a form stating, "I demand X." The responder
either accepts .tbe oHer and receives her portion of the money as allocated by the
proposer or reiects the offer, leaving both parties with nothing. Traditional models
of rat10nal actors predict that the proposer will offer the responder only slightly
more than zero aud that the responder vvill accept any offer greater than zero. The
results, however, show that individuals incorporate fairness considerations into
their offers and choices. The average demand by the proposer was for less than 70
percent of the pie, both for first-time players and for players repeating the game
one week later. In fact, the most frequent offer from the proposer was an even split
of the money. In additi011, individuals in the role of the responder rejected
profitable but unequal offers routinely; offers for less than 20 percent were
usually rejected.
People oflen rely 011 attaining what they consider to be a fair or justifiable
result. As a result, they are often willing to pay to punisli their opponent if he or
she asks for too much. Ochs and Hoth (1989) studied a situation in which the
responder could reject the allocation offer of the proposer, then counterpropose
an allocal1on. However, the amount of money shrank if the responder rejected
the first offer. The res.earchers found that in such ultimatum games, 81 percent of
rejected offers were followed by disadvantageous counteroffers in which parties
who rejected the initial offer demanded less than they had just been offered. Ochs
and Hoth argue that players' utilities for fairness can explain the results. However,
they also argue that a simple uotion of equality does not explain the data, since in
most cases the proposer asks for more than 50 percent of the resources in the first
stage. Hather, parties realize that the other side may very well refuse offers
perceived as unfair despite the economic rationality of accepting them.
Fair dictators? Ochs and Roth had participants play either an ultimatum
g.ame like the one just described or a "dictator" game in which the proposer could
how the resources would be split without the responder's accep-
tance. I hey found that while many proposers chose a 50:50 split in the ultimatum
game, none proposed a 100:0 split. By contrast, under the dictator format, 36
percent of all proposers took 100 percent. When acceptance was required,
proposals became more equal. However, in the dictator game, when acceptance
by the otl1er party was not required, 64 percent still chose to give the other party
some port10n o1 the resources.
Pay-what-you-want pricing employs a real-life version of the dictator game
According to this concept, rather than paying a fixed price for a product as
typically occurs, consumers have the opportunity to pay any price of their
choosing. Thus, a consumer could theoretically pmchase a product for $0 and
"free ride." In this situation, the consumer has all the power. However, even
though consumers could theoretically free ride in a pay-what-you-want pricing
situation, not all take this chance. In a study of photo sales from an amusement
138 Chapter 8: Fairness and Ethics in Decision Making
park ride, Gneezy, Gneezy, Nelson, a!ld Brown (2010) provide evidence. that
pay-what-you-want pricing can actually be more profitable than a normal pn_crng
scheme, particularly when the choice tc pay appears vntuous because a p01t10n
of the proceeds will go to a charitable cause. Refreshingly, it appears that feelmg
a sense of social obligation can go a long way toward encouragmg fair behav10rs,
even when selfishness is easy.
These results demonstrate that both a desire to be fair and the realization that
being unfair can generate social sanctions led to choices tliat deviated from rational
models in systematic and predictable directions. . . . .
The persistent desire for fairness: Many intmt that it is not difficult
to sacrifice a few dollars to punish an unfair allocat10n m the ultimatum game, but
that people would behave more rationally if the stakes \Nere sufficiently high. The
evidence contradicts this intuition. A number of studies have vaned the stakes 111 the
ultimatum game and found no appreciable effect on behavior-even when the total
pie was equal to several months' wages. Au even split remains the most common
offer from proposers, and responders routinely reject any offer less 20
(Cameron, 1999; Hoffman, McCabe, & Smith, 1996; Straub & Murmghan, 199.:i).
Neuroirnaging techniques pinpoint the role of_ emotional react10ns m the
ultimatum game. Functional magnetic resonance nnagmg technology
allows scientists to see how blood flows to different parts of the brmu m
time. Decision scientists vvho arc interested in the mechanisms behind people. s
observed choices have used flvlRis to determine which part of the bram rs
activated under different conditions. Saufey et al. scanned players' _brains
as they received ultimatum-game offers either from another person or _iron'.
computer. The researchers found different patterns 111 bram activation _fm unlmr
offers and for fair offers, and the differences were greater when these offers came
from another person than when they came from a computer. A region associate<l
with negative emotional states (the anterior.insuala) was stimulated when
considered unfair offers, as was another reg10n that the authors hypothesized was
connected to the cognitive demands of the task (the dorsolateral prefrontal co1:tex),
namely the desire to make as much money as possible. The .greater emol1011al
response for unfair offers provides concrete evidence that emotional processes a1 e
involved in this type of decision making.
There is surprising cross-cultural consistency in. the way people play the
ultimatum game. Henrich ct al. (2001) conducted studies that mcluded the game
in 15 societies around the world. This re.search found little support for the classic
economic view of self-interest; fairness was found to be an importm1t factor m
these economic games for each of the societies tested. However, d1e researchers
did find that the patterns of everyday interaction explamed .between
societies. Fairness appears lo be a universal concept affectrng dec1s1ons, but
implementation of fairness depends on cultural norms.'. . .
Hesearch by Brosnan and de Waal (2003) even oflers a cornpellmg demon-
stration of cross-species generality in fairness judgments. They showed that
capuchin monkeys rebelled when they \Nern given snrnller rewards .than
fellow monkeys for performing the same task, m much t.
1
.1e same way that m1equal
When H
1
e are Concerned about the Outcomes of Others 139
f,ayment undermines workers' motivation (Fehr, Kirchsteiger, & Reid!, 1993).
Ihese ang1y capuchins inclig11antly refused to work or even to eat their cucumbers
if their neighbors received much tastier grapes in exchange for performing the
same labor.
\VHEN '1VE ARE CONCEUNED ABOUT THE OUTCOMES
OPOTHEUS
IIurnans_ and capucl1in moukeys botl1 care aLout what happens to others. People
may wiHmgly pay m order to harm an aclversmy or forgo gains to help a loved one.
In people are concerned about how their own rewards compare to the
rewards of others. Recognizing these co11cerns, organizations create elaborate job
grade systems to specify the compensation available to employees at each level
witluu the organization. Salaries, bo11uses, aud benefits arc carefully calculated
w1thm these specified parameters so employees will believe they are being fairly
compensated relative to others in comparable positions. In addition, organizations
stnve lo conceal salaiy data to avoid social comparisons and perceptions of
unfairness. Tlus elaLoratc behavior is j_nstificd by research showi
11
g a positive
correlat10n between the pay equity of co11JOrations and the quality of tlteir
proclucls (_Cowherd & Levine, 1992). Similarly, Dcpken (2000) shows a negative
relationslup between the size o1 paydifferentials withi11 a l\!lajor League Baseball
team and how well that team perlonns, judging by the objective standard of
1vmumg percentage. Namely, the smaller the gap between the highest-paid aml
the lowest-paid members, lhe better the learn as a whole works together. Clearly,
across a broad variety of situations, individuals exhibit concern for how their own
re\vards compare to those of relevant others and also show resulting chan<Tes in
their own behavior. b
Top executives in firms are also impacted by fairness considerations
resulting from social comparison. In a study of S&P 500 firms, Fredrickson,
Davis-Blake,. and Sanders (2010) found that pay differences among the top
executives w1tluu a firm were negatively correlated ;-vith firm performance. Top
executives must work together as a team, and large pay disparities undermine
tlus collaboration.
As recent college graduates entering the workforce learn, significant differ-
ences in payment exist across industries. Those who go into investment banking
imght earn $100,000 or more iu their first year while their similarly qualified peers
m pubhslnng or architecture make less than half that amount. How can such
unfair differences persist in the market? Two particularly interestin<T
facts about this cross-industry wage differential can be explained by how we
fairness concerns (Thaler, 1991). First, there is an observed correlation between
high-profit industries and high wages. Second, if one job within an industry is
highly paid, other jobs in that industiy also tend to be highly paid. Our perceptions
of the lair comparison wage are related lo tl1e profitaLility of a given firm and what
otlter individuals in close0
1
related jobs cau cam (Akerlof & Y'ellen, 1990). When
oil companies or banks are highly profitable, they routinely share some of these
1'!0 Chapter 8: Fairness and Ethics in Decision Making
profits with their workers, even if the profits are due to factors, such as currency
exchange rales or global oil prices, that lie far outside tl1e control of any of the
firm's employees (Bertrand & Mullainathan, 2001). This suggests that people
make comparisons within their firm and to other firms in their industry rather than
across industries. This may account for the acceptance of differences in payment
between iuduslries such as banking and publishing.
Chapter 5 shows that people ofte1 compare what they have against a
reference point Sometimes the status quo, such as one s current wealth, serves
as the reference point (Kalrneman & Tversky, 1979). However, Loewenstein,
Thompson, and Bazerman (1989) argue that the outcomes of others commonly
act as a key reference point in interpersonal decision settings and that inter-
persoual comparisons can overwhelm 2oncern for personal outcomes when
people rate potential resolutions of a dispute. For example, in an experiment that
asked participants to assess multiple outcomes to a dispute one at a time,
individuals typically rated $500 for oneself and $500 for another person as a
more satisfactory outcome than $600 for oneself and $800 for the other.
Bazerman, Loewenstein, and \iVhite (1992) combined the logic on how concerns
for others influence our decisions with the work on joint-versus-separate
preference reversals from Chapter 5 to examine whe;1 people are concerned
with the outcomes of others. In the first empirical demonstration ofjoint-versus-
separate preference reversals, Bazerman et aL (1992) showed that while
individuals care far more about social comparisons when rating a specific
outcome, absolute individual outcornes are more important in actual choice
behavior. Seventy percent rated the outcome of $400 for oneself and $400 for
the other party as 111ore acceptable than $500 for oneself and $700 for the other
party when asked to evaluate these ontcomes separately. However, only 22
percent chose $400 for oneself and $400 for the other party over $500 for oneself
and $700 for the other party when asked to choose between the two. This basic
pattern is consistent across many other comparisons and across a wide variety of
contexts. \iVhen a series of joint outcomes are evaluated individually, the
outcomes of others become the reference point. \iVhen choosing bel:\veen
lvvo outcomes for oneself, tbe outcomes of others are not needed as a reference
point, since the lwo outcomes can be compared. In this type of situation,
the outcomes of others become less relevant. Instead, the salient atlribute in a
choice task is one's own outcome.
l3lount and Bazerman (1996) extended this result to a real situation involving
real payoffs. They agreed to recruit participants for a colleague's experiment. One
group of potential participants was offered $7 to participate in a 40-minute
experiment, knowing that all participants would be receiving $7. A second group
was offered $8 to participate in a 40-minute experiment, knowing thal some
participants were arbitrarily (based on the last digit of their social security number)
being offered $10. A third group was given an opportu1ity (1) to participate in a
110-minute experiment in which eve1yone was being pa.cl $7; (2) lo pa1ticipale in
a 10-miuute experiment in which some participants, iuclmling themselves, would
receive $8 and others would receive $10; or (3) not to participate. Although
1Vhe11 lVe are Co - z b I
, nce111ec a out tie Outcomes of Others 141
significantly more participants in the first r I . . .
than in the second rou J (.55 Jer, g .c l_ose lo part1c1pate (72 percent)
group (.56 IJercent) cY10selto IJ'tlt .. _ce1t1l)'. lhle DMJOllty o1 part1c1pant.s in the third
'l ic1pa em t 1e expe - ttl I
some others were given $10 (16 . I , I 11men tat gave t lern $8 while
pe1 cent close t
1
e e . .
1
. I
received $7 28 . , . l xpenment m w 11c l eve1yone
, pe1 cent e iose not lo partieip1t . . I ) , l
evaluated whether to IJart1'c1"pale . 'fi ' e 111 e1L ter ' r lUS, when people
m one spec1 1c exrJe - t ti ,.
potential participants were critical to thei - I : .. umen ' le outcomes ot other
options were available p1rtici Jauts - , bi l ec1s1ons. However, when multiple
across the n IL' l ' ' . 1 we1 e d e to compare what they would receive
I u ip e expenmcnts and the oul , f I
important ' comes
0
ot 1ers became less
willi findlings are consistent with the affect heuristic introduced in Cha1Jter 1
wo1' on JOmt-versus s t f '
5'. .and with the e

ien we assess one option at f . I . .
points we use lo . . a ime, socrn comparisons serve as reference
assess om outcomes. Dut when rn Ir
1
. . .
easier to compare across them d cl",. d I I u
1
P e options exist, it becomes
an is1egm tie ess useful comparison to others.
Perverse Consequences of Equality Norms
The responder's expectations in an ultimatum , . - . - .
norm of eqml1"ty 111 ti lt-' g.une ,u e pa1 l.1ally affected bv a
' le u 11natum gune f /
rejection of economically desirable offers , o leald to the
norms of equalitv can cause u , , . " , '. " . . a so poss1 e t mt t le same
(1991) idenffi , s to accept fau situations too prematurely. Messick
1 ies many contexts lll wluch individual, , . . .
when a rational malysis \VO Id t . s expect an even split, even
' u no support sucl1 1 1 t Tl . I
individuals acce]Jt an equal allocalion f l , _ , ' sp
1
. ie ease wit l which
large meisure r
01
. lll .
0
P edsUJe and pam probably accounts, in
' ' u e cornmon use of co - I .
Consider tl1e ]] . mpi on use so ul!ons m negotiation.
.o owrng s1tuat10n:
You visit a car tlealer and go
0 1
. t t I" y
in the showroom rea I a es c ou return lo the salesperson's cubicle
I
.. a . . , dy lo do a deal. 1he car has a list price of $18 000 Aft ..
s 101 t iscuss1011 you offer $15 500 Tl . I , . e1 a
. l ' . ' . le sa esperson ,counters with $17 600
counter wit 1 $16 000 he , t .. . ] $ ' , you
. l I . ' ' coun e1s wit l Ii ,200, you counter with $16 400 , d l ,
iec uces us price to $16 800 y , t, . 'f . ' 'an lt.
thre'lten to vist tl . ' l ,I ou de dS I you will not make another move ancl
' 1 ano 1er c ea ershiIJ The I , I
loo! 11 . . sa esperson t ien says earnestly "You
c
1
'
8
a mce person, aud I cau see that vo .. II 1 1 l '
is that you aet tl . tl , . '
/
u
1
ea Y
1
<e t ie car. My main concern
md I \\>111tbto b1e_cai rnt you want I assume that you are a reasonable person
' ' e 1 easonahle Ho h t [ 1 . '
w a ou
1
we spit the diflerence-$16,600?"
Manv of us would qu l<l . l
1
..
sound ( - , , . . ic y accept l 1e sa esmau's ofier. After all, a 50:50 s lit
s 1lits s_ au . .1 et'. cm e.1ul cons1derat1011 reveals that this 50:50 split, like most 5l5o
l ' is qmte di b1tia1y. The final two numbers on the table could have b
, 16,000 and $16,400, and the 50:50 split would have sounded u. . . - een
resultrng pnce would have been $16 900 - $400 l 'fl r . J st as fau, but the
cl I I '
01
css. le rn1rness of 1 5050 J't
fairness of the two numbers used
ec1s10n ma <:e1 must be aware of the influeuce of a seemingly fair
142 Chapter 8: Fairness and Ethics in Decision Making
50:50 split and realize that other 50:50 alternatives are easy lo generate. Just
because an offer can be considered fair does not mean that it is optimal. Other
equally fair outcomes may exist that would be better for you. . .
Again, we see that fairness concerns do influence clec:csions and that 1gnormg
others' fairness concerns can be costly. People are entitled to tl1eir own assess-
ments of fairness. However, we must all realize that others may have very differe11t
standards about what is fair.
WHY DO FAIRNESS JUDGMENTS MATTEH.?
One reason we should care about whether others think our actions are fair is that they
will punish us for behaving unfairly. People engage in such punishment even .when
doing so is not in their rational self interest. For example, when responders m the
one-shot, anonymous ultimatum game reject offers, they are choosing to forego a
monetary gain in order to punish the proposer for making an unfair allocation.
Indeed, research shows that obse1vers who are not personally affected by
unfair treatment are actually willing to pay money in order to punish others whom
they observe behaving unfairly (Fehr & Fischbacher, 2003; Fehr & Gachter,
2000). Fehr and Fischbacher (2004) had participants in d1eir expernnent play a
dictator game \Nith a twist. In addition to the dictator and the recipient, there was
also a third-party obseiver. The obse1ver could see what tlte dictator provided the
recipient and could decide whether to punish d1e dictator for the allocation.
punishment was costly: For every $1 the obseiver paid to pumsh, the dictators
own payment was reduced by $3. Note that no purely seH-mterested observer
would ever engage in such altruistic punishment, which is costly to both the
dictator and the punisher, and provides no economic benefit. 55
percent of obse1vers chose to punish dictators who gave less than hall .of their
money Lo their recipients. The less dictators gave, the more they were pumshed by
the observers.
Fehr and his colleagues argue that their evidence shovvs that people actually
derive measurable satisfaction from "altruistic punishment" that allows Lbem lo
teach a lesson to a cheater. The researchers have shown tl11t effective punishment
of a cheater is anticipated by greater activity in the dorsal striaturn, a braiu
region that delivers the satisfaction of attaining a desirable outcome (de Queivain
et al., 2004).
Judgments of fairness permeate organizational life. Comparisons of pay raises,
tl1e distribution of scarce budgets, promotions, grades, and prices are just a few of
die many situations in which we make fairness judgments !hat affect our emotio:1s
and behavior. It is probably not realistic to attempt to eliminate concerns for
fairness and social comparisons from our <lecision-mal<ing repertoire. Never-
theless, when faced vvith the question of whether you should go to the effort
to punish an individual or a firm that behaved unfairly, rational decision makers
may want to consider the internal conflict that we explored in Chapter 6 between
the "want" and the "should" self. You may be angry and want to pumsh someone,
but should you? Would doing so truly be in your interest?
Bounded Ethicality 143
. Even if you ignore fairness concerns in your own judgments, there is ample
evidence that people will use fairness and social-comparison information to
Judge your actions, Thus, understanding how people judge fairness may help
you make better dec1s10ns 111 both your personal and professional life. In the
half of this chapter, we turn from thinking about how people evaluate the
fairness of others' actions to the issue of ethics. Jn contrast to fairness issues
ethical issues concern how we judge our own behavior and its consistency
our own values.
BOUNDED ETHICALITY
Following the many COJ})Orate scandals that coincided with the start of the new
millennium, the media looked for the underlying cause of the unethical behavior
Popular targets of the media's blame included a handful of "bad" people \Nithin
firms such as Enron and its auditor, Arthur Andersen, gatekeepers vvithin these
companies, aud failed governmental regulation. Business leaders were blamed for
their role in the presumed ethical clecline, and business schools vvere criticized for
failing to provide ethical training lo future leaders.
Tlte media implied that the key to stemming the tide of fiuancial scandals was
Lo stop managers from decidiug to. engage in uuethical behavior. This approach is
broadly consistent with tlie field of etl1ics, which focuses on deliberative decisions.
In this section, we will challenge this ethical perspective on corporate scandals. vVe
are .m favor of changing the incentives of organizational actors to encourage more
etlucal behav10r ancl would be pleased to see genuiue corporate criminals seive
tune m pnson. But recent research provides a compelling case that the vast
ma3onty of unetlucal behaviors occur without the conscious intention to behave
unethically.
We focus on tl1e cognitive biases that lead honorable people to engage in
unethical behav10r without realizing that tl1ey are doing so. The first half of this
chapter examined the ways in which fairness judgments depart from standard
economic models. This second half of tl1e chapter how cognitive biases
allow us to act m ways lhal contradict our own intended standard of ethics. These
from our intended standard are systematic and predictable, just as the
biases irom rationality discussed in Chapters 2 through 7 are predictable and
systematic. Rather than eoncentratiug on iutentionally corrupt behavior, we will
discuss recent research that identifies the types, magnitude, and causes of
unethical behavior that occur without the awareness of the actor-what we refer
to as bounded ethicality (Chugh, Bazerrnan, & Banaji, 2005) This perspective
diverges from standard treatments of ethics, which assume the explicit analysis of
appropriate action by the individual, yet complements this traditional
Our argument fa that understanding and changing the ethicality of
human act1011 reqrnres gomg beyond the common assumption that ethically
challenged behav10r results from people choosing self-rewarding behavior over
what is right. New evidence points to the limitations of the conscious mind and
emphasizes the power of the unconscious mind to motivate us to engage in
144 Chapter 8: Fairness and Ethics in Decision Making
unethical behavior (Banaji & Bhaskar, 2000; Murnighan, Cantelon, & Elyashiv,
2004; Wegner, 2002). .
We use the term "bounded ethicality" to refer to the psychological processes
that lead people to engage in ethically questionable that are inconsistent
with their own preferred ethics. Bounded etl11cahty comes mto play when m1
executive makes a decision that not only ha.nns others but also is mconsIStent with
his or her conscious beliefs and preferences. Managers develop protective
cognitions that lead them to engage in behaviors that they would condemn
upon further reflection or awareness. When they become aware of ai:
questionable situation that is not formally part of their responsi.bility, tl1ey rna) Lu!
to get involved. They may have no trouble justifyi'.1g their maction etl11cal;
greater reflection, however, they might recogmze maction to be more harmful than
many errors of action. Clmgh (2004) argues that bounded ethicality is exacerbated
by the pace of managerial life, which demands the speed and dec1s1veness tliat
System 1 thinking (discussed in Chapter 1) provides. System 1 tlnnla.ng the
biases created by bounded ethicalily to develop, wl11ch m turn lead lo dec1s1ons
that deviate from one's personal standards. .
Like the other biases reviewed in this book, the biases emanatmg from
bounded ethicality apply to all of us, even the best and the brightest. In March
2004, for example, Supreme Court Justice Antonin Scaha demed a rnot1011 from
the Sierra Club to recuse himself from an upcoming case, Cheney. v. ffS.
District Court for D.C. Scalia had hJnted ducks in with Vice
President Dick Cheney in January 2004, just three weeks after the .Sup.reme
Court agreed to consider whether Cheney should be to .provide mlo:-
mation about the energy task force he led as the Bush adrnnustration
its environmental policy. The Sierra Club argued that Scaha and .Cheney s
friendship compromised Scalia's objectivity. "If it is reasonable to _that a
Supreme Court justice can be bought so cheap, the nation. ism houble
than I had imagined," Scalia wrote in defense of lus dec1s101: (J 2.004)
His friendship with the vice president would not mtenhonally. ,cl1s.to1 t Ins
judgment, Scalia argued, and did not violate the Supreme Comt s rnles 011
conflicts of interest.
But the rules governing the Supreme Court, like most guidelines, rules, and
laws that protect against conHict of interest, were to guard only
intentional corruption (Banaji, 2004). Scalia's comments md1cate that he either
chose to ignore or is unaware of the strong evidence of the psychological aspec:s of
conflict of interest. In this section, we will provide eVIdence tliat even the st11ctesl
guidelines are generally insufficient to address conflicts of interest that es.cape the
awareness of the professional being affected. For instance, psychologists have
1 n tllat a bond between two IJeorJle can make it impossible ior one lo
S 10W l 19()4
objectively assess issues involving the other (Murray & Ho ' _ . I .
This chapter overviews six examples. of bounded
credit without realizing that you are domg so, m-group favontism, miphcit
attitudes, indirectly unethical behavior, p:;eudo-sacred vo.lues, and the psycl1ology
of conflicts of interest. H.egarding conflicts of interest, we exannne both how they
Overclaiming Credit 145
affect our decisions and how they motivate us lo be blind to the ethical infractions
of 0Ll1ers. For each type of bounded ethicality, we present research showing that
such behaviors occur beyond conscious awareness.
OVERCLAllHING CREDIT
Hoss and Sicoly. (1979) asked married couples to estimate the percentage of
household activ1hes, such as washing the dishes or taking out the trash, they each
personally performed. 'When the percentages offered by husbands and wives were
added, the. per-couple average was close lo 140 percent. Since this original
demonstration by Ross and Sicoly, overclaiming of credit for work performed
has been demonstrated in academia (Caruso, Epley, & Bazermau, 2006), athletics
(Brawley, 1984; & Schlenker, 1977), and fundraising (Zander, 1971), just
to name a few helds (see Caruso, Epley, & Bazennan, 2005 for a review). The
roots of overclaiming are the self-serving biases reviewed in Chapter 6. Even
honest people tend to believe they contrilmted more to an enterprise than they
actually did.
Overclaiming can also he a factor at the organizational level. Hesearchers
have puzzled over the question of why joint ventures so often end in disap-
pomtment (Epley, Caruso, & Bazerman, 2006). One possible drawback of
strategic partnerships is that parties are oft.en skeptical that the other side is
doing its share. It is a widely known problem that joint venture partners often
contribute mediocre talent to the enterprise, rather than their firms' best talent.
Why? In part because each party has an incentive to save its best talent for
projects that the firm is fully invested in rather than on projects of which it owns
only half. vVhen we factor in the tendency of each side to overclaim credit for its
own contribution, it becomes apparent that each side will feel entitled to reduce
its contribution. Consequently, each side views the other side's behavior to be
unfair and its own behavior to be justified, aud the escalation of sinister
attributions about the other party spirals downward.
Can anything be done to stop individuals and org1111izations from overclaiming
credit? Caruso, Epley, and Bazerman (2007) asked Harvard MBA students to
estimate 11ow much of the work clone in their study groups t11ey personally had
completed. vVheu tlrn researchers added up members' claims by group, the
average total was 139 percent. In 0Ll1er words, the members of the average group
believed that they were responsible for 139 percent of the 100 percent of work
completed. However, when the researchers first asked group members to think
about the contribution of each member, including themselves, the average total of
the claimed work done by the group fell to 121 percent. While "unpacking"
mcliv:iduals' contributions to the group effort did not cause the overclaiming of
credit to disappear, it did at least reduce the magnitude of the bias. Furthermore,
in a study of academic authorship of articles that had between three and six
authors, the same researchers found that overclaiming was rampant and that
unpacking reduced overclaiming. In addition, the greater the magnitude of
overclaiming, the less parties wa11lecl to work together in the future.
146 Chapter 8: Fairness and Ethics in Decision Making
Essentially, improving the perspective-taldng skills of group members can
help reduce overclaiming and raise group performance, In addition, overclaim-
ing may have important implications for the longevity of groups, The next time a
colleague makes a claim that you view to be outrageous, before arguing, consider
that you yourself might also be guilty of the tendency to overclairn credit In
addition, remember that it is far more likely that your colleague is biased than
dishonest
IN-GROUP FAVOIUTISM
Think about some of the favors you've been asked to perform in recent years,
vvhether for a friend, a relative, a friend of a friend, or a friend of a relative, I-lave
you helped someone get concert tickets, an apartment rental, admission to a
school, or a job? Most of us are glad to :
1
1elp out with such favors, More often
than not, we have done them for people like ourselves-people who went lo the
same college, people we work \vith, or people who happen to be of the same
race, A basic psychological finding is that we tend to identify with people who are
a lot like us, ln addilion, we are more comfortable doing favors for those with
whom we identify than for those noticeably different from us, Thus, we tilt
toward helping people who share our nationality, religion, race, gender, or
alma mater,
This all sounds rather innocent what's wrong with asking your neighbor, the
admissions officer at the nearby college, to check up on a coworker's son's college
application? Isn't it just "networking" to recommend a former sorority sister for a
job or to talk to your banker cousin when a friend from ;lrnrch gets down
for a home loan? A favor is a favor no matter who you re helpmg, nght?
Few people set out to exclude underrepresented minorities through such
acts of kindness, Uut when those in the majority tend to favor people who are
similar to them when allocating scarce resources (such as jobs, college admis-
sions, and mortgages), they effectively discriminate against those who are
different from them, Consistent with tlie work on implicit attitudes that we
will discuss later in the chapter, Dasgupta (2004) has reviewed almost 100
research studies that show that people have a greater tendency to associate
positive characteristics with their "in-groups" (groups they t,o) than with
"out-groups" (groups they do not belong to) and to more easily associate uegahve
characterislics with out-gronps than with their in-groups, Moreover, Bernhard,
Fischbacher, and Fehr (2006) have shovm that people's willingness to enforce
social norms by punishing those who treat others unfairly is much greater when
those treated unfairly are similar to ther1selves with respect to ethmc, racial, or
language group, These discriminatory patterns can result from both automatic,
implicit processes and thoughtful, explicit processes, ,
People often regard the favors they do for in-group members as virtuous,
without the harm that these favors may create for out-group members,
Even as we congratulate ourselves for doing something nice for a member of our
"conununity," we overlook the ethical implications of the favoritism we pe1vetuate
Implicit Attitudes 14 7
iu, the In-group favoritism, or giving "extra credit" for shared demographic
h,uts, is

pumslung people for being different from you, Yet helping

people vd10 are like us is viewed by, society as a nice thing to do, while
d1scrnnmatmg agamst those who are different is viewed as unethicaL
Over the last decade, studies have repeatedly shown that banks are much
more to deny a mortgage to an African American than to a Caucasian,
even after controllmg for a variety of factors, including income, house location,
and so OJL The common view is that banks are overtly hostile to the African-
community, For some banks and some loan officers, this may be the
c,1s,e" But Messick and Bazerman (1996) argue that a much more common-and
of discriminatory, mortgage lending is likely to Le in-group
fm outism, That is, wlnte loan officers may Le making too many loans to
unqualified wlntes, G1ve11 a limited pool of resources, fewer funds remain
available ior nonwhite applicants,
, The lead,ing form of affirmative action at many top-ranked U,S, colleges and
umvers1hes is legacy or the policy of admitting unqualified or
margmally lJUahfied cluldren of alumni, donors, am! other well-connected
rnd1v1duals, according to Peter Schmidt, the deputy editor of the Chronicle
of Higher Eclucatfon (20?7), At many of the nation's most prestigious colleges,
less ,capable appl1ca11ts horn privileged social groups are favored over more
unconnected applicants, In fact, "legacies" make up 10-15 percent of
f1eshman classes, at most Ivy League schools, Yet according to a 1990 Depart-
;;1eut, of Educat1011 report, the typical Harvard University legacy student is
less qualified" the average non-legacy student in eveiy
ie.levant a1ea but sports (The Economist, 2004), Just as mortgage lenders are
p10b_ably unaware that they are disadvantaging mi11ority borrowers when they
favor, Caucaswns, umvers,1ty officials likely are blind to the fact that their legacy
policies d1scnnunate agamst less-connected but more qualified applicants,
IMPLICIT ATTITUDES
l\!Iost,people think of their attitudes, including their attitudes toward various races,
a: w1th111 the scope of their conscious awareness and under their controL
1 lus view is challenged Ly research 011 implicit attitudes, which shows, for
mstance, that when' we meet someone, our minds automatically activate stereo-
types of lhe persons race, sex, and age (Macrae & 13odenhausen, 2001), Even
people. who believe strongly in egalitarian values cannot help but have unflattering
ste1eotypes come to mmd w1lhout conscious awareness or intent For example,
Bargh, Chen, and Burrows (1996) had participants in their experiment work on a
Lonng cornputer task Meanwhile, the computers flashed subliminal images of
e1lhcr wlute or Llack faces, so quickly that parlicipants were not consciously aware
oi theuL when the computers "broke down" and the participants were informed
that their work had been lost, those who had been shown black faces responded
vVILh s1gmficalltly more aggression than those shown while faces, cousislent with
tlie common stereotype of African Americans as aggressive and violent
148 Chapter 8: Fairness and Ethics in Decision Making
The existence of automatic or unconscious attitudes and their effects on our
judgments can place important bounds on the degree to which we can assure that
our own behavior is consistent with the ethical values we \Vant to express,
Unconscious attitudes influence the information that is immediately accessiLle
to us, which interacts with situational demands to shape our decision makiug
(Jefferis & Fazio, 2008), Again, evidence shovvs that human ethicality is bounded,
People often provide sincere and strenuous denials that they intended to behave in
ways consistent vvith negative racial stereotypes, Nevertheless, their explicit
intentions are contradicted by the implications of their actions,
Research by Jennifer Hicheson and l1er colleagues shows that Americans of
European ancestiy are often less comfortable interacting with Americans of
African ancestry than with Americans of European ancestry (Richeson & Shelton,
2005; Shellon, Ilicheson, & Vorauer, 2006), Those of European ancestiy do not
intend to behave poorly toward African Americans, but they display clear
psychological signals of discomfort Indeed, those people whose automatically
activated stereotypes are the most negative suffer the most discomfort in inter-
racial interactions (Hicheson & Trawalter, 2005), In fact, the hard work of
suppressing their negative racial stereotypes produces measurable cognitive
impairments on olher tasks (Richeson &: Shelton, 2003),
Psychologists have developed a useful tool for examining our implicit attitudes
regar<ling race, gender, and other human differences that are weighted with
stereotypes: the Implicit Associations Test, or IAT (Greenwald, IVIcGhee, &
Schwartz, 1998), The IAT is one of the most interesting an<l controversial
psychological tests ever developed because it offers the potential to assess altitudes
that most people woul<l rather not reveaL Unlike most psychological testing tools,
it is very difficult to consciously manipulate one's IAT scores, The IAT cannot
reveal whether or not someone is racist, sexist, and so orL Rather, it measures the
strength of an individual's implicit association between two pairs of categories,
such as White/Black and Good/Bad,
The IAT, which is usually administered via computer, works as follows, The
test-taker is instructed to categorize items that appear on the screen as quickly as
possible by striking keys on the keyboard, The items that appear on the screen
might come from one of four categories, such as 'White," "Black," "Good," and
"Bad,'' If you were shown a series of pictures of people's faces, you might be
asked to press one key to indicate that the face belongs to a "Black" person and to
press a different key to indicate that the face belongs to a "'vVhite" person, You
might also be shown words such as "Hate," "Love," "Kill," aml "Heal," which you
would have to categorize by pressing tl1e key for "Good" or the key for "Bacl:'
The lyJJical test includes a series of rounds, In some rounds, "White" faces and
"Bad" words belong to the same category and should be categorized using the
same key; meanwhile, "Black" faces and "Good" words belong to the same category
and shoul<l be categorized using the same key, In other rounds, 'vVhite" faces are
assigned to "Good" words and "Black" faces to "Bad" words,
Hesearch using the IAT to study stereotyping and prejudice has produced
some iuteresting results, Nosek, Banaji, and Greeuwakl (2002) report that
Implicit 1lttitudes 149
roughly three-quarters of the while A .. " l , , . ,
implicitharvarcLedu) exhibit 10 their Web site (http://
about your own implicit 1ttitucle I l t altt1tuc es. (If you are wondering
IAT Web site ) 0 .. , b r you can ta o;:e t 1e IAT yourself by visiting the
more uickl ." d n ot I wlnte and black Americans perform the test
"Bl , Iy <111 accu1 ately wheu they must associate "White" w1" tl1 "Go l" cl
ac c wit I "B I" ti . l l oc an
"Black" with "G ,, T1lan w ien It iey must associate "\\lhite" with "Bad" and
o c, iese resu ls m1ply that t f l 1 ,
if uncouscious, associations that le1d us .t r:' mos! o us iave l eeply mgrainecl,
it comes to race, '
0
avor w nteness over blackness when
Many people are SlllJJrised lo discover 1 r ] , I
expression of implicit attitl1des 1ea1. l" lv\ itt e control they have ov.er the
' b'rcmg race gender , ,. . I . (
Bazerman, & Chugh 200
3
) B . ,
1
, , ' , ' age, ,me so on Banaji,
L , , ecause nnp 1c1t 1ttitudes t ] , l
mental IJrocesses of cate , t" ' a1 e. roo cc m ore .. inar)1
' gonza 1011 perceptio cl ,
(2001) has called the use of tl1ese, , tt"t cl i'.: nd1emory, au judgme1.1t, Banaji
. a I u es or nn1y , [, " SI

.captufres the

xp1 ess1ons o stereot)'IJes and . , cl, . _ "] , ,
1
,
managers, executives and tl . , f'o ," I , p1e3u ice, t ien o1c ma1y
, o ie1 pi o ess10na s will demonstrate them
, Blanton ancl J accarcl (2006) advise JAT test- . I . , . , - - , , .
mmd vvhen inter1)reting the". , , l\f , ta <e1s to keep. se.ve1 al factors m
ll sc01 es, . ost unporl'lntly tl IAT , l I
relative strength of implicit attitude but not tl 0, - , T z' 1e . i eve a s t ie
words i[ the le t - .. I I , , . ieu a 'JSO ute st1 ength, In other
' s I evea s t iat you assocnte T j ,
than with bhck faces ti t cl . . ' . gooc ness more with white faces
level ou l . . . , ta oes not necessarily mean that, OH a subconscious
feel lb;alcklpeople, Instead, it could be that you
,,
1
e ,me u ac ( 1)eo1Jlc b t tl t ] ]"
more positive feeliu s tow -cl l , . . ' u ia you iavc s ightly
hate both white and gblack ar - w :1te peo.ple;. conversely: it could be that you
than black people, people but that you hate wlnte people slightly less
Psychologists have found that implicit altitudes Jredict cerhi , ,
behav10r, Rudman and Borgida (1995) h, f cl II . , , , ' n Io1 ms of
l
)redicted di"s . ," , t" . , ave oun t Mt 11nphc1t slereol)'IJes
curnma ion agamst fen ] ' , L l"
(2001) found that st cl t" ', 11,t e JO app icants, Itud.rnan and Glick
u Y pm 1c1pants w 10 held str r , J" , , 1
women with communal trails (e g l l f l) . cl ong '.mp all1tuc :s connecting
alistic, traits (e,g,, ambitious) we1:e an 1:1enc w1lh age11tll\'m individn-
as having poor social skills tl. - ... " ," y to view d female,ex.h1L1tmg ambition
this dimensiorL McConnell pl11 t1c1p,111ts with weaker nnplicit attitudes on
highly predictive of no ' In l be1l o d (2001) found tlrnt m1plicit attitudes were
, , m e1 Ja e rnv1ors toward different " - r I
Fmally, Asendorp( Banse, and Muecke (2002) d .. lb1loups o peop e,
tudes are more r cl" . , , emonst1atec t iat unphcit atti-
more xedicliv/ol ool spontaneous behaviors and that explicit attitudes are
are m;re likely to bflrnv101s, Tiius effect nnplies that implicit attitudes
thinking, w ien c ec1s1on ma cers arc using System 1 thau System 2
One possible real world I f ] , l
Louis G t J. . examp e o l us p ienornenon was the arrest of Henry
C
, l a es L, dn ucan-Amencan Harvard University ]Jrofessor b 1 , .
1
ow ey, a wlutc Carnbrid, M . I . , . ' Y , dmes
(B
. , . ge, ass,1c msetts police seraeant on July 16 9009
aze1rnan & 1enbrunsel 201 l) U , b, , ,
, , . , pon returnmg home from au overseas trip,
150 Chapter 8: Fairness and Ethics in Decision Malcing
Gates was unable to open his front door, so he forcecl his way insicle with the help
of his cab driver, After a neighbor reported a possible break-in to the police,
Crowley arrived. Gates showed Crowley proof of his resiJence. Yet Crowley later
saicl that he felt compelled to make an arrest after Gates reporleuly liecarne
disorderly while Lhe men were standing on Gates' s front porch. Gates was held for
four hours and charge<l with <lisorderly conduct. The charges were droppeJ
several clays later, but Crowley refused to apologize for his actions. The inci<leut
became a cause celebre when PresiJent Barack Obama said at a press conference
that the Carnbri<lge policy had "acted sl:upidly" in arresting Gates. To defose the
public debates on race that followed, Obama convened a "beer summit" with
Gates, Crowley, and Vice President Joe Eiden at the White .House Hose Ganlen.
Many people who condemned Crowley's decision to arrest Gales on the porch
of his own home assumed that the officer must be an overt racist. But consi<ler that
Crowley actually teaches a course to police cadets on how to avoid racial profiling.
It seems more plausible that Crowley, when required lo make a snap judgment
aliout Gates, may have fallen victim lo the type of subconscious racial bias
identified by the IAT. Crowley's System l thinldng could have prompted
unconscious racial attitudes that cause<l him to decide to arrest Gales. As noted
above, the less time we have to think, the more likely we are to succumb to racial
bias. In one study using a computer simulation, participants were instructed to
shoot criminals that crossed the screen, but not the unarmed citizens or police
ol1icers; the participants incorrectly shot more black men than white men (Correll
et al., 2007).
Some researchers have noted a societal shift over the last few decades from
"ol<l-fashionecl racism" to "modern racism" (Brief, Dietz, Cohen, Pugh, & Vaslow,
2000; Clrngh, 2004). Old-fashioned racism is explicit and accompanied by hostility.
Modern racism is more sulitle, but affects managers' professional ju<lgments
nonetheless. In 2004, Morgan Stanley paid $54 million lo settle a sex clisciimina-
tion lavvsuit liled on behalf of some of its female executives by the Equal
Employment Opportunity Commission. The EEOC argued that much of the
problem at Morgan Stanley, and at other investment banks, is that the mostly white
men who are in charge do not seem to recognize the existence of gender inequities
in their operations (New York Times, July 14, 2004, p. Cl). Hydie Summer, a
plaintiff in a separate sex discrimination lawsuit at Merrill Lynch, commented,
"[The brokerage managers] really don't lielieve they are discriminating. ff you
come in an<l you look like they want you to look-probably a white male profi.le-
they'll project success for you. They have a specific view of what a successful
broker or manager will look like, a:1d it is not usually a woman or a black or
Hispanic." We all need to be aware that racial attitudes can affect our judgment
without our conscious awareness and in ways that a:ce at odds with our inleutions
and values.
There is some evillence that as we become less prejudiced as a society, our
tendency to implicitly employ stereotypes in our decision-making process may be
recluce<l. One such example comes in the election of Barack Obama as ll1e first
African-American president of the United States. Plant and colleagues (2009)
. Indirectly Unethical Behavior 15 l
1Jrov1de evi [ tl
. l ence mt implicit 1ttitucl , b
a. fler Obama's election than the' y \Ve _es a. out bllack people became less IJreJ" ndicecl
tl t tl cl
1
e pnor to lis 1 t l
la us rop m implicit 1Jre3udice occ . . l l e cc mu. T le authors also argue
cxe [ - f" Af. UJ JC< < ue to mer cl
, 1Up a1 o ncan Americans It . l ease exposure to a IJOsitive
. l ' dppears t mt ll.S - , b -
g1 oups rnve an opportuuity to sncce d . 1 . 1 '. m01 e mem crs o1 stigmatized
we will become as a society. e Ill ug 1-status positions, the less prejudiced
INDIUECTLY UNETHICAL BEIIA VIOU
Imagine that a major pharmaceutical . .
rnncer drug. The <lrug is not profitabl:01i1pm1y is the sole marketer of a particular
size, yet the patients who do buy tl ,<lc-ue to! !ugh fixed costs a_ ml a small market
I
Jh . . I ie I ug c e1Jencl "t 1 l .
aunaceutica company current] . cl I on l or t ieu survival. The
only sells it for $3/1Ji]l. A IJrice . , y p1 o. uces_ t ie drug at a total cost of $5/1Jil! and
n . 111c1 ease 1s unlike! t cl
w.1 nnpose significant hardsl111J o11 y o ecrease use of the drug but
many users H I
1
'
company to raise the p1ice of th cl. f- . . _ow et 11ca would it be for the
Now imagine that inste l ef . mg rnm $3/p1ll to $9/pill?
t l ' ac o ra1smg the - ti
o proc uce the drug to a smaller lesser-] puce, ie company sold the rights
meeting between the two co . , mown pharmaceutical comrnn)' At
"S mpmues, a young , t"
1
.. . ' a
mce our reputation is not as c -t 1 execu ive iom the smaller firm s1ys
' u ica as yours cl '
eye, we can raise the price five fold t $15/ "ll " , an we are not in the public's
and marketing iights to the other fi o , l p1 .. Would selling the manufacturing
l'aharia, Kassam Green . d Bum ie rno1e or less ethical?
. I
1
- _ ' e, ,m azerrna11 (2007) D cl
eac l o tliese two o1Jtions i11cl1vd . 11 . . oun that when evaluati11g
., . l J ua y, partic . t f cl .
J aise l ie drug price to $9 per ill tlnn . ipan_ s oun it more unethical to
knowing that the other Hrm - .' tlo sen oil the product to another firm
g
. f . . raise lie pnce to $1"' . .
11
'
roup o partic1pa11ts was direct!)' 'tsl d t . J pe1 p1 . VVhen another
tJ {" el ' (e 0 comrn tJ
1ey oun the Lehavior that led t . $15 . . de ie two options, however
13 o a per ]] . b '
ut as we discussed in Chapte. 5 - . , . p1 pnce to e more unethical
at a lime rather than corn1Jllri11g1 . cl' people typically ob.serve only one behavior
t .. - l . . ' ell! conlrnstmg t r .
o srnip y ra1smg the price of ti l. . l "' o optwns. Thus, as compared
company is a disguised, ambi uot:; .t o_f the drug to the smaller
concerns from the public-y!t at 1,usrng tactic that is less likely to raise
the drug's users. , 'rne tm1e, it may be more hazardous to
Could this type of indirect price in , . , l
aud, in fact, some firms seen t . cl1.ease 1appen in the real world? Yes-
A
1
o specia 1ze 111 c l" I
d
ugust 20_ 05, pharmaceutical rnmuf:1ct .. !VI iel,a mg su_c 1 opportunities. In
. b l ' ' UJ e1 ere c \ I . l 1 cl
I ug y t le name M ustargen sold ti - . , v nc I la made a cancer
product to Ovation Pharmace:1tic I 1e ugi1ts to manufacture and market the
that specializes in buying slow-a sI,Ja nmc tclsmaller, _less-recognized compan)1
co se mg me icmes f b l
mp_ ames. Ovation soon raised ti 1 l l . J om ig P iarmacentical
[ > r cl JC w 10 esa e ]Jnce f M
. eu imes, espite no investment in RxD . o. ustargen by roughly
m the study described abov M . l c . o1 any other significant new costs. As
had raised the price of the e1 c < might have faced a public backhsh if i"t
b
1 ug on its own B t b '
was a le to raise the drug price u . . u ecause Ovation is so small it
w1 wut attracting much attentio11 . cl M , l
, dn ere<
152 Chapter 8: Fairness and Ethics in Decision Making
was able to avoid public accountability for effectively raising the price of the
drug tenfold.
Dana, Weber, and Kuang (2007) present intriguing evidence on this issue of
camouflaging the intentionality behind exploitative actions. Their study suggests
that people who cany out such "indirect unethical behavior" may do so as much
to protect their self-perceptions as to influence the perceptions of others.
Participants in their study played a peculiar dictator game in which half of
them had to choose between two options. One option gave them $5 and the
other person $5. The second option gave them $6 but gave the other person $1.
Participants in the "baseline" condition had all of this information. Seventy-four
percent of them chose the first option over the second option, giving an equal $.5
payment to each player. By contrast participants in the "hidden payoff'
condition saw that the first option would pay them $5 and that the second
option would pay them $6; however, they would have to click on a box to learn
what the consequence of their decision would be for the other party. Half of
these participants chose not to click; among this half, all chose the second option,
which gave them $6 and the other person $1. Hemaining willfully ignorant of the
larger consequences of their choices allowed them to choose selfishly. (One
additional interesting result: recipients who were only given a dollar were more
forgiving of the dictator's choice when tltey learned that the dictator had willfully
chosen not to find out how the choice would impact the recipient than when the
dictator knew the consequences of the action. It seems that keeping yourself
ignorant about the possible negative repercussions of your selfish behavior
might, at least in some circumstances, be in your selfish interest.)
More evidence that keeping others in the dark facilitates our selfish behavior
comes from Dana, Cain, and Dawes (2006). They gave raiticipants in their study
a choice: either (1) play a standard dictator game in which they could allocate
$10 between themselves and another person who would know about the game and
their choice, or (2) exit the game silently and receive $9, knowing that the other
person would receive nothing and would never even know about the existence of
the game. Houghly one third of participants took the "sllent exit" option, a choice
that is difficult to justify as rational, as a self-interested person should play the
standard dictator game and simply allocate the entire $10 to himself or herself.
The people who chose the $9 silent exit apparently wanted to behave selfishly but
felt more comfortable doing so when they could keep their selfislrness secret.
WHEN VALUES SEEM SACRED
Many people have values that they claim to hold s<;.cred. For instance, most
ethical systems, including most religions, hold life to be sacred. However, as
suggested by Tetlock's (HJ86) concept of value pluralism, the world rarely allows
us to hold a single principle as sacred. Instead, life is full of difficult choices that
demand that we balance one value against another. Some ethical systems that
hold life sacred also maintain that people should not interfere with life's natural
processes and therefore should not practice birth control. While both the
When Values Seem Sacred 153
Homa11 Catholic Church and the fr I . L , , .
tj . . a a1 arna s T1behn B ddl . b
us view, the Dalai Lama (189
9
) . l . ' u 11srn su scribe to
D l
. ac rnowledges 1 tnd 11- 1 . .
a ai Lama argues that ] , I . ' ' eo on t 11s issue. The
' lllll1dll popu at10n gro .1t] d .
those already on the IJhuet "' I . \\ l Is en angermg the lives of
' v1 e oug it to worr)' t 1 b
Earth's ability tu sushin I . . . . .l . no on.ya out exceedincr tltc
, , ' imnctn popu at10n, accordin ! . , b
,tlso dbout non-human forms of1r cl"l g to tie D<1Lu Lama, but
l
11e. 1e percenl'lge of l t I .
t iat go extinct each y C'l - . , l . l . . ' P an anc anunaI species
. . 'I JS as lJg l today as it W'lS ! . l
extrnctJon event some 250 . 11 ' c mmg t le great Permian
1
. . . , nu 1011 years ago, when 90 . , . 1 ,
ivmg species went extinct (Beuton, 2005) , , ., . pe1cent o the Larth s
world will no doubt l o . . . .Such J ad1cal changes to the natural
cl
1r . iave I epe1 cuss1ons for lmnnn 1 f . l l . .
1 JCU!t to antici11ate alJ of tJ . cl"J .. f. ' I e, a t 10ugJi It can be
l
. . . iem. ie m erence the D l 1 . . l .
umtnw human jJO!Juhti . ] . . '
1
ell craws is that
[
1
b. ' on g10wt l is a responsible w t , ffi. I
o tie lives already
011
the Earth. dy
0
d um t 1e sacredness
Tetlock, Peterson, and Lerner (1996) . t .
stances, people are usuall n. porn out that, under some circum-
d
' y w1 mg to cornpronuse on v1] , ti . . l
sacre . I< or instance the D l . L , . ' ues ut t iey regard as
' d a1 ama s concern for the ] ,
of the potential lives that birtl1 COJ1t. 1 11 1Vmg co.mes at the expense
' 10 Vil rweveut It.,. l 1 l
must consider tndeoffs L
0
,,. " l . JS d so o tent 1e case that we
' u cween sacrec issues" ( ] . , 1 l . .
Tetlock, Kristel Elson G. " , d I . sue 1 dS tie va ue of life) am] wlrnt
, , ieen, au (2000) ,, ]] " I .
value of money). Tetlock et al (2000) . .. . Cd seen ar issues" (such as the
cl
. exanune how JJeo11le cl , I . l 1
conun rum of conside1111g t ., d . [[: 1 . ea. wit l t le wrenchina
1a eo s t iat mvt tl . b
sacred values. The most comm . , I e lem to compromise on their
outrage" and "cleansing,, I<' .. are what the authors refor to as "moral
01 ms ance t ieir resrJ cl t
at the ve1y idea of allowing 111 ! l . , I . I l on eu s expre.ssed moral outracre
r m 'e s m w uc l mnn 1 b d b L b
rnvors would be bought and sold I. . 'I o y parts, au1es, or sexual
l
.
11 1
esponse the 1nrtici . t, , d
c eansmg rituals that involved distancin l ' . ' . p,m s engage 111 mental
they had been asked to consd . , l gt i.ernselves f1om the reprehensible idea
1 01
anl agreemg to volu t" . ti .
more moral!)' acce11ta1le It . t n ee1 ieir tune to work on
u a e1na 1Ves.
vVithout a doubt, moral judgments are often str l .. , , . . ". . ,
emotional reactions Peo 1 .. 11 ong y <lssoci<tted with powerful
P e usuc1 Y assume th1t tl f.
1
assessments. However, I-laidt (2001 2007) .. , emotions o low moral
fact, it is more common for tlie , t p1 esents evidence that, in
oppos1 e lo occur Iu oth , . 1
produce ernolional reactions wl . I ti , l . . . e1 WOH s, our moral issues
S
' Hc
1
ien c uve our more
ume of Haidt's stroilgest e d f. cogmtive assessments.
v1 euce comes ro t . l. , . l .
an issue with emotions lhat the ' cannot i'.u1 u,1 ions rn w nch people reacl to
guide their decisions. ) expl,nn or Justify but that nevert11eless
. For instance, Haidt, Bjorklund, and Ml. l - .
ipants $2 lo sign a ;01111 (1 .. d ' . 11 P iy .(2007) oUcred their JJartic-
' nspu e uy an e1J1s l 1 Tl S.
hereby sell my soul 1fter m 'cl , tl l S . oc e o ie im]isons) that read "1
smn ofnvo dollars.''. the b) ttea 1,1.ol cott Murphy [the experimenter], for the
l
o om o tie page a 11rmted t - , 1 " l . .
egal or binding contract "I) t , . . ' no e 1 eat : T us is not a
, ' . a1 ic1pants were told th t tl Id l
lorm as well as the $2 and th t tl lcJ l " iey cou 'eep the signed
including tearing it u11 s ,1 .t1ey cou lo whatever th.ey liked with the form
, mce 1 was mem 1 . d
1
'
selling their souls Neverthel 77 ' mg ess an t 1ey were not actually
. ess, percent of rnrtic ' . t '
who claimed not to believe . tl " . . - ' ipan s-even many of those
111 lt. existence of souls-refused the chance to make
154 Chapter 8: Fairness and Ethics in Decision lHalcing
a quick $2. when asked lo explain their refusal, participants could not articulate
a sensible explanation beyond the fact that they simply didn't want to sign the
contract. Here, as elsewhere, moral objections were driven primarily by emotion
rather than reason.
THE PSYCHOLOGY OF CONI<'LICTS OF ][NTEREST
Financial advisers often earn fees based on the transactions they recommend to
their clients. Surgeons typically earn more when they operate than when they don't
operate, and doctors often receive payment for recommending patients for clinical
trials. Commission-paid lawyers are more likely to recommend settling a case than
are lawyers who are paid by the hour. Real-estate agents earn their living from our
housing transactions. Merger-and-acquisition experts typically are paid only when
a transaction occurs, and sometimes Supreme Court justices rule on cases
involving their friends.
Most members of these professions would agree that a conflict of interest
exists in many of these examples between receiving persoual benefits (such as
money or a hunting trip with friends) and doing what is best for their clients, their
patients, or society at large. These same professionals, however, assume that they
themselves are immune from such conflicts of interest. Likewise, it would be
natural for the authors of this book to believe that the degree lo which a job
candidate's research affirms our own research never would affect our opinions in a
faculty hiring decision. After all, we consider ourselves to be honest and objective
people. Not only do we believe that we ourselves are immune from conflicts of
interest, but we believe that the professionals giving us advice can overcome
them as well.
This common belief in our own objectivity and the objectivity of our advisers
belies the clear evidence that conflicts of interest are less likely lo lead to conscious
corruption than they are to distort our judgments in ways that we are not even
aware are occurring. When a real-estate agent advises you lo raise your offer
beyond what a rational assessment would suggest, the point is not that she is
corrupt, but simply that she is human and therefor:= implicitly motivatecl to
maximize her own benefits from the {leal. Because of this, she will focus on
anecdotal evidence suggesting that buyers would prefer to overpay a bit for a house
rather than run the risk of losing it. When we are motivated to interpret or alter
dala in a direction that will benefit us financially or otherwise, we are not capable of
providing others with an objective assessment (Moore, Cain, Loewenstein, &
Bazermau, 2005). This is true of doctors, lawyers, real-estate agents, professors,
and olher professionals.
Many people believe that disclosure is the best solution to conHicts of interest.
In the words of former U.S. senator Phillip Hart, 'Sunlight is the best dis-
infectant." Disclosure is attractive in part because it does little to disrupt the
status quo: Parties need only report wha.t they are doing. Conseque11tly, disclosure
is one of the most common responses to conflicts of interest. Disclosure of
donations to politicians and political parties is the centerpiece of most
The Psychology of Conflicts of Interest 155
campaign-finance legislatiou l d. l .
TH!e IV of the eingol<l Act_of 1997. Most of
to issues of disclosure Pi- f" Y_ al _I, \du ch I egulates au<l1tmg, is dedicated
o ess1on associatw ,1 1 I
Association and the Society fo - 1>. f" . I ns, me uc mg t le American Medical
. . - . I Io ess10na Journalists I . cl f" l .
mst1 uct tl1e1r meniLeis t d I '
1
ave co es o et 11cs tint
0 !SC ose IJOtenf l n f. '
York Stock Exchange. rn con icts o. mterest, as does the New
l3ut disclosure is not a panacea. In fac. C . .
present evidence suggesting tl . t d. l t,. am, Loewenste.m, and Moore (2005)
cl
rn 1sc osme can actu Jl . _? b"
stu y, the researchers assig11e l b , a y mc1 ease ms. In their
1
," . c one mem er of e1ch - f
o estunator" and the otl1er to tl1 . I f" cl . ' "pan o participants to t11e role
. e IO e o a v1ser B tl t ,
to estimate tl1e amount of 1110 I 11 . l . o I pa1 ic1panls vvere asked
cl
. ney 1e c m eac 1 of six fill cl 1 .
a v1serwasabletoins11ecte"cI111 I I , pis I e. wit1co111s. Each
" Jc coseyan<latle ti 11 1
only look at tl1e Jars briefi cl f .. I . . . ng 1, w 11 et ie estimators could
Y an 1 om a ong distance Tl l
to provide advice to his or he1 ti t - b l . ie ac v1sers were then asked
. es ma 01 a out t 1e m t r .
Estunalors were always IY11cl n - 1 1 . . , wun o money m the jars.
. ' 1 01 e w ien t ieir es tun. l .
atlv1sers had a conflict of i"11te. t tl l. . a es were more accurate. Tlie
res ie more t Jell" e r t . .
much money was in the Ja. ti . I . s Ima ms overe. stm1ate<l how
l
. l,
1
e mo1e t 1e advisers were "cl ]
ac v1sers had an incentive to .. l d I . . . . pm , Ill ot 1er words,
(2005) told some of the mt,o guessing high. Cain et al.
nothing about it to tl1e rest of tl . e a<lvise1 s pay arrangerneut but said
, , ie estnnators.
U1e results showed that advisers wl10s . . fl" . . . . . .
provided more biased guesses C l . l , e con icts of mte1est were disclosed
advisers whose motives were ie; of coin-jar values) than did
estimators to discount tl1e1 . d . sc ,oseclc . n ct . ition, disclosure did not cause
I a VJSers a VICe rn , ti Tl .
advisers to make more moile . d . su icwn Y. rns, disclosure led
Y au estimators to m ] 1 , I I
without disclosure. This raise tl - l .b. . a <e ess t ian t iey would have
s ie 1ea poss1 1hty that . f,
1 1
to disclose conflicts of inte e t l . cl" . pi o ess1ona s w 10 are force cl
I s , sue l as au itors n11gl t b If.
those who do not make such disclosures ' 1 e more se -serving than
Motivaled blindness. Why did Artimr Ander. . , ,
flawed accounting? We bel1 ti t 1 cl sen ,1ccept Enron s blatant])'
eve rn t 1e An ersen , d"t . Jk
been guilty of the motiv1tional b" f . _au I o1s were I ely to have
, ' ms o mterpretmg i <l " . I ,
i.avorable to maintaining tl1e J t . 1 . l . , , n sea1c ung wr data
l
c 1en 1 e at10ns np A <l"t .
1
. l .
t mt they can make independent and b-. cl . du I o1s lclve ong claimed
books. At the same time tl1e . d"t . un iase JU gments about their clients'
' se au I o1s t)'jJically w1 t t . . . 1
to sell services to tlie I 'n .
0
mamtam t 1ese clients
m, or even to see, job [- ti . ,
possible that most au<lito1s 11e l t s 10111 1e111 m the future. It is quite
' 10nes. enough to cl . cl tl . .
lead to intentionally corru1Jt au<lt B t . I , vo1 _ie mcentJves that could
l
i ,
1
s. u as ong as auditors c <l cl
t leir c wnts for future coiit .. 't .t . . ,u e epen ent on
l dC S, l IS not IJOSS1b!e tl b
unbiased. Contrary to tlie f f tl cl"
01 1
c111 to e completely
b cl
oeus o le me ia on finding . cl . l . l ,
a apj)les damaging the U S fi . l dn pums llng t 1e few
mancrn system the .. I cl
clear that dee1)ly ingrai11e<l 1 l t.t t 1 fl ' I esea1c 1 ev1 ence makes it
'
1
s I u 10na con icts of t 1
for pleasing their clients were large! . "bl _er est t mt reward auditors
v. , ll y 1espons1 e 101 the cns1s
. 11 tucl y all humans tend to view data from . . . . .
mgly, when an auditing fi . cl cl . a se se1vmg pe1 spect1ve. Accord-
n
111
epen s on a client lor fi rn al 1
il is not psychologically possible . tl . di. . . r nc1. or consu tmg business,
. 01 ie au to1 to mmnta111 true independence of
156 Chapter 8: Fairness and Ethics in Decision Malci11g
. & Moore 2002 Bazerrnan, Morgan, &
judgment (Bazerrnan, Loewenstem, lit - . would require fun<la-
Loewenstein, 1997). Creating true !ant OI m ditors ancl their clients, such that
l l
t tl e relationship )etween au
men ta. c ianges o
1
. . l . tl . _ clients Our society has not yet
mclitors do not have a motivation to p ease ren . d . d
' l 1 all of cre1ting true auditor m epen ence.
confronted t ie c 1 enges ' f ,b cl _ ixobl<,
111
that we refer lo as
j . 1 t illustrates a ar roa er , cl
In act, l us s ory . ' 1 1 l e ar1 incentive not lo notice . ata,
d bl . d N el)' w ien r)eop e iav
motivate zn ness. am ' l - t s sto11 es motivated blindness
-I 1 t I severa iecen new , .
they are able to over oo ( . n t' tl 1etl11'cal behavior of others. Soon
1
. b
1
. cl tl f 'lure to no ice ie m
appears to ie . e un le ai l l f , l t independence in investment
l . I ls broke the ac < o ana ys l f
after the auc itor scanc ct ' . d tl e. vivid exarni)le of couf ict o
c f nedia attention an ano l r '
banks became a rocus o i . C Clnirr)erson Laura Unger
l b world Former actmg ' .
interest in t re usmess . l l t' ne 1.l1at the NASDAQ was m
cl
f g t mt at t re same 11
cited a 2000 survey ocumen m G'o t 99 1 percent of brokerage-house
1 l d its value by percen '
a clecline t iat c ecrease ' . " . B ,, "B " or "Hold." Brokerage
cl f were still Strong uy, uy, b
analysts' recommen a wns . t the amount of business clone Y
firms often tiecl analyst compensat10l n . ob . l gives analysts an incentive
, l 1 cl a practice t mt o v1ous Y tl .
the finns t iey ana yze ' l . l tl companies ancl overlook ieir
. . t' . lations 1ir)s wit 1 . rese
to main tam pos1 IVe 1 e
unethical behavior. . b - 2007 a rer)ort issuecl by former
1 l . a nr)le m Deeem er , L 11
To tarn anot ier ex ' ' l [ 80 Ma3or League Base a
M't ,1 11 revealed tie names o ' l
senator George . 1 c ie . l t ns who were allegecl to have usec
players, representing all 30 imlJOI edague e:ir l Stand-outs on the list
l
Jerfonmmce-enhancing steroids an g1 ow l t cl l . 1 2007 broke Hank
1
t R - Clemens Barry Bon s, w ion
inclucled pitc iin_g grea. oger 11 . '1 d - n cueer home runs; and MLB
, cl b the a -time ea er i ' , l cl
Aaron s recor to ecome . l d ' d p ttitte Jn 2009 the news lea (e
l 1vl"guel TejaC a an 1'-11 Y e ' r .
superstars sue t as i l ers who had tested positive ror usmg
that the MLB had known of at least 100 p ayf ccusations against him, New York
l d -ugs In the ace o a ' d
l)erformance-en rnncmg
1
cl . Ii drugs from 2001-2003. An
l I., d . z idmitte to usmg sue d .
Yankees star A ex _,o ugue ' l t ti ingle-year home run reeor m
2010 M k McGwire w 10 se ie s , .
in J anuaiy , ai . . , 1,1 cl steroids over a periocl of ten years m
1998, admitted he had penocl1ca y USE
his career. . .cl clal b seball fans tend to blame the players
In response to the sterm s - . a ti But several factors gave players
cl
r . cl . r ng the sr)ort s 1 eputa OIL , . . l
who cheate ior arnagi d . . l cl' ig cutthroat com1Jet1tion, mge
. . ge in opmg me u n
strong incentives lo eng,1 l , . t t bl the fact that MLB team
. f . J) . ners and per raps mos no a y, d d
salanes or top per on , d bl. d t steroid use for many years. In ee ,
owners and manage_me.nt turne a m eye od ti l k of penalties, players may
1 f clopmg the spm t an ie ac cl 1
given the preva ence o . f . - 1 d . itage if they staye c ean
have felt they would have been at an un an usa wr
(Bazerman & Tenbrunsel, 2011). 1 , g drngs was an open secret in
The wiclespread use of journalists and even some
Lase ball during the 1990s ancll tis. :Jroblem a blight upon the
. LB l rere voca m ca mg ie .c l .
lorrner M p ,1yei s "' . l r onecl rapid clrmnatic c ianges m
S[)Ort. Yet MLB leaders appear not to 1ave quels B l vVliy dicl they look the
i
. 1 IJhyers sue l as one
the pliysique ancl per ormance o ' ,
The Psychology of Conflicts of Interest 157
other wayr It seems they may have succumbed to motivated blinclness. Artificially
pumped-up players were breaking performance records and boostillg garne
atlenclance and TV viewership. Addressing steroid use would have jeopardized
league revenues. These financial benefits prevented MLB management from
noticing problems they had reason not to see. As we have noted, 'when people have
a stake in a certain outcome, it is almost impossible for them to view relevant
information without bias. That's why broad policy changes are usually needed to
address motivated blindness. Amid the firestorm of the steroids scandal, the MLB
instituted a strict policy of random drug testing; only then did steroid use by
players appear lo fall dramatically.
Motivated blindness can cause leaders throughout society to engage in
unethical behaviors that they woulcl condemn vv:ith greater awareness. The child
sexual abuse scandals that have rocked tlrn Catholic Church in the United Stales
are one example. For decades, at clirect odds vvith its mission of helping and
protecting children, the Church's hierarchy allowed abuse to ru11 rampant. To take
one example, Cardinal Bernard F. Law, the archbishop of Boston, overlooked the
huge amount of child abuse committed by priests under his watch. In court papers,
he adrnittecl he had returned John J. Geoghan lo parish work despite knowing that
the priest hacl Geen accused of child abuse. Geoghan, later convicted as a child
molester, was just oue of many criminals whom Lmv kept active in the priesthood
(Bazennan & Tenbrunsel, 2011)
A former civil rights activist, Law had committed himself to a life of serving
oll1ers, including children and other defenseless memliers of society. Law appears
to have beeu a11 ethical person who made so.me extremely unethical and possibly
illegal clecisions in the course of this service. Why? Law testified that he allowed his
decisions to lie swayed by outclatecl medical and psychiatric advice concerniug the
ability of child abusers to curtail their behavior He likely hoped lhat the abusers
coulcl be reformed. He also had an incentive lo cover up the aliuse, lest the
Church's reputation be tarnished. These desires appear to have blinded Law to the
clear eviclence that the abusers would repeat their crimes.
Entire organizations, ancl even inclustries, can be susceptilile to motivatecl
blindness, as in the case of credit-ratiug agencies 'in the lead-up to the 2008
financial crisis. Credit-rating agencies are responsible for eclucating outside
stakeholders of the creclitworthiness of issuers of debt obligations, including
for-profit ancl nonprofit organizations ancl governments, and the debt instruments
these financial organizations sell to the public. During the housing bubble, many
delit issuers began to bundle aHcl sell subprime and other high-risk home loans as
mortgage-backed securities. In their independent assessments, credit-rating
agencies failed to accurately rate the risldness of these securities. Afrer the
financial crisis struck, the House Oversight ancl Government Heform Committee
founcl evidence that executives at the rating agencies were "well aware that there
was little basis for giving AAA raliugs to thousands of increasingly complex
mortgage-related securities, but the companies often vouched for them anyway,"
accorcling to the committee's chairman, Hepreseutalive Henry vVaxman (D-CA)
(Swanson, 2008)
158 Chapter 8: Fairness and Ethics in Decision Malci11g
Here again, motivated blindness appears to have led to Hawed decision
making. Fonner credit-rating agency executives testified lo the House commit-
tee that a conflict of interest makes it difficult for the U.S. credit-rating system
to perform as intende<l. Specifically, the largest agenciE)s (including Standard
& Poor's, Moody's, and Fitch) are paid by the companies they rate rather than
by the investors who have a true stake in the ratings. Credit-rating agencies exist
to provide objective analyses, yet their compensatioll displays an inl1erent
conflict of interest. Now consi<ler that the agencies made huge profits during
the housing bubble by giving top ratings to securities and debt issuers. The
promise of these profits motivated them to turn a blind eye to the extreme levels
of risk the debt issuers were promoting during this time. Despite the catastrophe
that followed, the federal government has failed to ae: to address the eredit-
rating agencies' conflict of interest, leaving them susceptible to motivated
blindness in the future.
What can we do about conflicts of interest? First, try to eliminate them by
avoiding advice from biased sources. Second, recognize that honesty does not solve
the problem of conflicts of interest, as even the most honest people are biased.
Finally, do not make the mistake of viewing yourself or your adviser as imn1une
from the pernicious effects of conflicts of interest.
CONCLUSION
Throughout the scandals that have scarred corporate America in recent years,
policy makers and the press have consistently sought to pin the blame 011 the
individuals at the heart of the crisis. Yet when we examine each scandal, it
becomes clear that it would not have been possible for just a few people to create
these problems if others around them had behaved ethically. From the classic
experiments of Milgram (1963) on obedience to authority, to Latane and
Darley's (1969) demonstrations of bystanders' inaction to cries of help, to the
contemporary research on implicit attitudes reviewed in this chapter, social
psychologists have shown again and again that humans make systemic errors,
inconsistent with their own desired ethics, that can profoundly harm others.
Much of this book considers the systematic and predictable errors that we
make against the criterion of rationality In this chapter, we have focused on the
ethical errors we make against the crite1ion of our intended ethicalily. VVe
have documented perceptual and cognitive errors that lead our ethicalily to be
bounded in ways that contradict our typical assumption of unbounded ethicality.
Most of us hold a stable view of ourselves as moral, competent, and deserving,
and thus immune from ethical failures (Banaji et al., 2003). This high self-regard
keeps us from monitoring our own behavior and bounded ethicality all the
more likely,
Ca11 ethics training help people behave more consistently with their values!'
Some knowledgeable observers argue tl1at the actual results of ethics traini11g are
disappoi11ting (Badaracco & Webb, 1995). Like Tenbruusel and Messick (2004),
we believe that most ethics training focuses too narrowly on explicitly unethical
Conclusion 159
behavior. The concept of bounded ethictlit . d l. .
escapes the actor's consc10 . , . ' y a c J esses unetlucal behavior that
. us awa1eness. Most IYl"l , . ti .
1
f I
etlncal IJeo1)le and lhe)' do i1ot . t t. 11 , 1Mge1 s 1111 c o. t :temselves as
, ' m en 10na y en<r-ige l
1
1. I .
therefore c1uestion wl1)' tl1e 'l Id 1 b' . m unet nca ue rnv1or. The)'
Y s 1ou waste t 1eir f 1 l
them to behave ethic'1lly Tl , . . une istenmg lo essons that tell
' 1e concepts presented tl l l . .
concerns that are j
1
Jcel)' t I . d '
1
m us c :tapter 11ghhght ethical
o 1ave escape l 1 . lt l
managers alike. e a entiou oi 10nest and dishonest
More than a decade and a h'1lf a o Mes . l
against the IJCrspective tl11t CJ l'. 'g f: , sic c and Bazerman (1996) argued
' ues 10us o executive tl b b
explicit tradeoffs between etl11 ' . cl . " . e ucs can . e . oiled down to
. cs ctn p1onts. Hather . , . cl l
psychological tendencies \Nill le id t . . l . l , we ,1sse1 te t rat a focus on
believe that the unconscious as 'Je et 1ical decision making. We now
best hope for im1Jroving indi .J od rnse _psychological tendencies oiler the
vr ua '
1
n 01 gamzat10nal ethics.
CHAPTER NINE
Common Investment Mlstal'-es
B eeause money managers are pai<l so han<lsomely for their work, investment
banks often have their pick of the best an<l the brightest It seems reasonable to
assume that these smart, hard-worldng people-who are generously rewarded
when their investments perform well-can find ways to invest your money that will
perform better than a passive index-fund strategy of putting your money in an
investment fund that tracks a broad market index of stock performances. Surely
even a mediocre money manager ought to be able to hand-select stocks that woul<l
perform better than an index fun<l.
'Nell, let's look at the data. Over time, the Vanguard Index .500 fund, which
tracks the S&P .500 (Standard & Poor's index of .500 large U.S. corporations),
has outperformed about 7.5 percent of the actively managed mutual funds iu
each year. Of course, you personally would not plan to invest in one of the
7.5 percent of fun<ls that performs worse than the market; you would choose
from among the top 2.5 percent. The only problem is that substantial evidence
demonstrates that past stock performance is not a good predictor oi iulure
performance. while some research suggests minor relationships between past
and future performance, these relationships have been small and ineonsistent.
That makes it very difficult to identify wUeh funds will be in the top 2.5 pereent
in the future.
There are a lot of mutual funds-approximately 8,000-ancl all of them are
being managed by people who would like you to believe d1ey ean outperform the
market, though only an average of 2.5 pereent \Nill sueceed in any given year. In
other words, each year approximately 2,000 of these 8,000 funds will outperform
the market. Of these, 2.5 percent, or .500, will outperform the market again the next
year. And among these winners, 2.5 percent, or roughly 125 funds, will again
outrerfonn the market for a third year in a row. The key lesson is that there will
always be funds that outperform the market for multiple years in a row, but this
trend will happen roughly at random, and past performance will still have little
predictive power.
By contrast, imlex funds are eertain to perform at the level of the overall
market to whieh they are indexed, minus a small operating fee. One reason index
funds outperform the majority of mutual funds is simply that their fees are so
low-often below 0.2 percent. Actively managed nmlual funds have far lngher
160
Common Investment 1"1istakes 161
expenses-often as high two pereent annually, or up to ten times higher than
some mclex funds. What. s more, the actively managed funds usually engage in
f1el1uent buymg and. sellmg of stoeks, leading to higher brokerage costs that are
subtraetecl from their returns. By definition, the aggregate of active funds (in
wluch managers choose stoeks) is likely to match the market, before fees are
s.ubtracted (Sharpe'. 1991). In the .end, high expenses significantly reduce the
ielums of these ael!vely managed funds.
Now eonsider the ease of hedge fonds, whieh exploded onto the investment
scene m reeent years. The amount of money u!lCler management by hedge fonds
has grown dramabeally, from $240 billion in 1998 to about $2.4 trillion by the
imddle of 2011 (BarelayHedge, 20I2). Hedge funds provide wealthy individuals
aud mstitutional mvestors an alternative to traditional investment vehicles. By
restnetmg who invest in them, he<lge funds avoid certain governmental
regulations mid d1selosures, thereby allowing their managers to maintain seereey
about their mvestment strategies. This secrecy, coupled with stories of speetaeular
gmns from certmn hedge funds, has built a mystique that has attracted substantial
investment. Furthermore, thanks to the high fees that hedge funds charge, their
managers tend to earn extremely high incomes, even by the impressive standards
of the mvestment banking industry. For instanee, CNNMoney estimated that
hedge-fund manager John Paulson took home $4.9 billion in 2010. This sort of
compensation has meant that hedge funds can attraet the best talent away from
banks. Has this talent translated into superior performanee?
The evidence suggests not. Kat and Palaro (2006) examined the performanee
of nearly 2,000 hedge 1n11ds and coneluded that only I8 perecnt outperformed
t.he relevantmarket Lenelunarks. The problem? As with actively managed mutual
funds, the high fees attached to hedge funds detraet from any returns they might
aclueve. It is standard for hedge funds to charge their investors "two and twenly"-
annual fee equal to two pereent of the total amount invested plus 20 percent
of any mvestment gmns (Cassidy, 2007). These fees are similar to those of the
most expensive actively managed mutual funds. Iu fact, hedge funds perform
even _worse than Kat and Palaro's (2006) data suggest, as they only
exaum1e<l ex1slmg hedge funds. As with nmtual funds, the losers go out of business
and thus are not included in long-term performance data. If the analysis ineluded
these "ghost" funds, performance would look even worse (Malkiel & Saha, 200.5).
No individual who buys an aetive mutual fund or invests in a hedge fund is
seekmg an mvestment that 'Arill perform far worse than average. Yet lots of people
and to hold onto such investments long alter receiving evidence
of their failure. 1he cost of these 111istakes adds up to billions of dollars. Why
do people make these mistakes? vVhile the answers ean Le fonnd in the preceding
chapters o{ tlus book, researchers have developed these insights into a new field
of inqui1y: behavioral finanee.
Essentially, Lehmrioral finanee is an application of what we know about
common judgment errors lo the world of investment. In the 1880s and early
1990s, behavioral decision research was applied most extensively to the area of
negotiation (which we will cover in Chapters 10 and 11). In recent years, the most
162 Chapter 9: Common Investment Mistakes
active area for new insights has been in the area of financial decisions. This
research gives us a better understanding of an important set of life decisions aud
also offers clear evidence that the decision errors described in this book are
broad in scope. Behavioral finance focuses on how biases affect both individuals
and markets. This chapter focuses on the former application; Shleifer (2000) and
Shefrin (2000) are good sources on the latter
In this chapter, we will specifically: (l) apply some of the core findings from
earlier chapters to investment decisions, (2) explore the scary practice ol day-
trading that became popular in the late 1990s, and (3) close with some clear,
common-sense investment advice. As you read, we encourage you lo compare
these insights to your own beliefs about investing and to your current investment
portfolio. Behavioral finance is, after all, an application of basic principles to a
specific decision domain. Consequently. you will notice that this chapter is
more practical and implies more specific advice than most of the other chapters
in this book.
THE PSYCHOLOGY OF POOR INVESTMENT DECISIONS
Investors love new books promising huge increases in stock market prices.
Glassman and Bassett's (1999) wildly optimistic book Dow: 36,000, for example,
received enormous media attention duri1g the giddy days of the dot-com boom.
Flipping Houses for Dummies (Roberts & Kraynak, 2006), which advised investors
on how to buy and sell houses for a qmck buck, was more emblematic of the
real-estate boom of the 2000s. Such titles achieve their success by exploiting
investor psychology. Motivated optimism and the confirmation bias are sufficient
to convince people with money in the market that their investments have a bnght
future. This is great for the authors who get rich from these books, but their
success does not usually translate into investing success for the books' readers. As
we have shown in earlier chapters, even very b1ight people make poor decisions
that cost time, profit, and, in some cases, their financial futures.
As you read tl1is chapter, our arguments against aclive investing may soun<l
strong. However, the evidence is overwhelming, and it contradicts the rnassive
amount of money and advice changing hands in financial markets. Investors pay
high fees to actively managed mutual funds and hedge funds, to to pick
slocks, and lo electronic trading companies to trade their money. Ihese fees are
how funds, brokers, and companies make their money. Are all of tlrnse investors
making mistakes? The great majority of them are. As Jason Zweig (2000) warned
the readers of Money Magazine, "The folks who run mutual funds have always
been good at cooking up clever ways to gouge you on fees, confuse you about
performance, make you pay unnecessary laxes and goad you into buying funds you
don't need."
The high rale of trading in the stock market has long been a mystery for
economists. H.ational economic agents should trade very little, and certainly
nowhere near as much as real investors trade (Grossman & Stiglitz, 1980;
Odean, 1999). The human biases we have reviewed in the preceding chapters
The Psychology of Poor Investment Decisions 163
do offer some ansvvers. Moreover, the financial professionals whose incomes
depend on the fees their clients pay are good at exploiting these biases. This
sectio_n will document how investment decisions are affected by: ( 1) over-
confidence; (2) optimism; (3) denying randorn events and the regression to the
mean; (4) anchonng, the status quo, and procrastination; and (5) prospect themy.
Overconfidence Produces Excessive Trading
lu Chapter 2, we offered evidence that people are generally overconfident with
respect to the precision of their knowledge, beliefa, and predictions. In the area of
mvesling, this overconfidence can translate into a tendency lo be excessively sure
t_hat know wluch the is headed or that you can pick the right
iund m to rnvest. l his overcouf1dence leads people to engage in more active
mvestmg. v\ hy should you be concerned about overconfidence? Because the data
strongly suggest that the stocks or actively managed mutual funds that yon pick
underperform the market, on average, despite your optimism.
Overconfidence is especially pertinent to stock-market investing strategies.
Tbe expenses associated with owning individual stocks are largely created by the
costs oflmying and selling them. These expenses, which include transaction costs
and differences between buy-and-sell prices, are dramatically higher for investors
who make frequent trades. Collectively, these expenses can add up to a surpris-
mgly large amount of money over time. vVhile we have argued that investing in an
mdex fuud is a. better strategy than frequent stock trades, it is not your only good
opl!o11. For an mveslor with a moderate amount of wealth, a low-cost alternative to
an index fund would be to buy a diversified portfolio of stocks and hold them for
many years. Thanks lo the of a variety of investment vehicles designed
to help you brnld a p01tfoho cheaply and conveniently, this strategy is becoming
easier and more commonplace (Zweig, 2000).
.. Unfortunately, many stock-market investors fail to recognize the advantages
of followmg tlus approach. Barber and Odean (2000) studied 66,465 households
that held an investment account with a large discount broker during the period
1981-1996. In contrast to the buy-and-hold strategy, the average account turned
over 75 percent of its portfolio annually. That is, on average, investors with this
brokerage house sold 7.5 percent of their investments in any given year. Similarly,
Carhart (1897) reports that the average turnover of mutual funds is 77 percent
annually, while the New York Stock Exchange determined that in 1999, its total
turnover rate was 78 percent. These numbers mark a dramatic increase since 1970,
wl1e11 the turnover rate for the New York Stock Exchange was 19 percent, and in
1980, when it was .36 percent. This growing frenzy can be attributed in part to
bnght people thmkmg they can predict the moves of the market. Are they right?
The average investor in the Barber and Odean (2000) database earned a
return of 16.4 percent during a boomiug market, just LS percent lower than the
overall market return of 17. 9 percent for this same period. Most interesting are the
20 percent of accounts (more than 12,000 accounts) that had the highest turnover
rates-those investors who actively traded stocks. Presumably, these iuvcstors
1G4 Chapter 9: Common Investment Mislalces
believe they can assess the direction stocks will take and are willing to incur the
costs of buying and selling stocks to own the "right" portfolio at the nght t11ne. On
average, the 20 percent with the highest turnover earned a return of JUSt 1L4
percent. Thus, in cornparisou to the overall market retun:, by spendmg lime and.
money tiying to track, buy, and sell stocks, investors lost b.5 percentage pomts.y
active trading is so hazardous to your wealth, why do so many people engage m it?
One simple explanation is that they are overconfident iu their ability Lo predict
where the market is going next.
Overconfidence does not affect the genders equally. Examining 35,000
investment accounts at a large discount brokerage, Barber and Odean (2001)
sorted the accounts by gender and found that women achieved better results than
men. In comparison to the market as a whole, women underperformed the
that they \Noukl have obtained by holding the same portfolio for a year by 1.12
annual percentage points, while in a similar comparison, men lost 2.65 percentage
points. Does this mean that women pick better stocks than .i;ien? No: Actual
returns of stocks picked by men and wJmen were not sigmfrcantly different.
!lather, turnover patterns differed; the men had a harder 1.irne sitting still. Women
had average turnover rates of 53 percent annually, while male turnover rates were
77 percent annually. It was the added costs of these more frequent. tra<les Lhat led
men to undcrperform women; with each trade, the brokers got ncher vvlule the
investors themselves fell further behind. Barber and conclude that over-
confidence among men leads to increaseC: turnover, which in turn leads to lower
performance after brokerage cosls are carved out of the returns. Before women
readers become overly satisfied about these findmgs, rt is important to note that
Barber and Odean are describing men performing worse than women whose
results are already far behind those of the market. In other words, women did less
badly than men-hardly an achievement worth celebrating.
Optimism about Investment Decisions
ff you have money invested in the stock market, what was the total percentage
return of your portfolio last year? Did yo1 beat the market-mother words, did
your performance compare favorably to the S&P 500? Now, go check your answers
based on the actual data: Look up your account statements or call your brokerage
or fund adviser, and don't forget to ask for last year's return on the S&P 500. I-low
did your memory of your performance compare to your actual performance?
Our guess is that your comparison will be consistent with evidence showmg
that people tend to be optimistic about a variety of behaviors, such as expected
career advancement, driving ability, elc. (see Chapter 2). Once people make an
iuvestment, they ten<l to be overly optimistic about its future profitability and later
maintain optimistic recollections of the investment's past performance. Optnrnsm
is closely related to overconfidence, yet distinct from it. \Vhen mvestors make
overly confident decisions, they will bold unwarranted optimism regardmg luture
success; retrospectively, they will maintain this optimism, even when the dis-
appointing results of their investments are easily available.
The Psychology of Poor Investment Decisions 165
Moore, Kurtzberg, Fox, and Bazennan (1999) created an investment simula-
tion based on the actual performance of the nine largest mutual funds, pins one
mdex fund, .over a t_ei1-year period, 198.5-1994. MBA students received a computer
program with an mvestmeut assignment. Starting vvith $100,000, for each six-
month simulated period, participants were allowed to invest their balance in any of
the .ten funds or m a money, market account, with the goal of maximizing their
endmg balance at the end of the simulated ten years. (The entire task took the
typical student 45 minutes lo complete.) After malting a six-month investment
decision, participants received extensive feedback on their return, the return of all
funds, and die return on the overall market; they were then prompted to place
thell' next six-month investment. Investing the entire account in the index fund for
the entire ten-year period would have led the $100,000 initial portfolio to grow to
$380,041. However, the average investor ended up with only $349,620 in his or her
account-a return consistent with the evidence from real-world databases pre-
sented earlier. The typical investor chose too many actively managed funds that
made too many trades and charged fees that were too high.
False optimism was clearly a factor in the participants' investment strategies.
Despite the fact that the market performed very well overall during this ten-year
penod, (1985-1994), participants consistently predicted that their portfolios would
grow faster for the next six-month interval tlian they actually did. Specifically,
participants predicted that their portfolios would rise 8.13 percent per six:-month
penod; m fact, they grew by only 5.50 percent. Even more interesting, participants
had optimistic illusions about their past performance: At the end of the game, most
participants reported that they had matched the market's performance. In fact,
participants obtained an average return 8 percent below the market. More
specifically, Moore et al. (1999) asked participants whether they had performed
(l) more than 15 percent below the market, (2) 10-15 percent Lelow the market,
(3) 5-10 percent below the market, (4) within 5 percent of the market, (5) 5-10
above the market, (6) 10-15 percent above the market, or (7) more than 15 percent
above the market. On average, participants overstated their performance by one
entire level.
In a parallel study, Goetzrnann and Peles (1997) obtained very similar results.
Participants remembered obtaining more favorable returns than they actually
obtamed. Goetzrnanu and Peles conclude that optimism helps investors justify their
past behaviors, allovving them to maintain illusions about the supe1iority of their
mvestrnent strategy. W'e argue that optimism also encourages investors to continue
active trading rather than pursuing wiser, lime-saving investments in index funds.
By the vvay, before reading this chapter, had you ever compared your
investment decisions to the market? Most investors have not. vVhy not? 'vVe argue
that most investors want to protect their overly optimistic view of their invest-
ments-and are vvilling to pay a high price to maintain their illusions. Similarly, if
you use an investment adviser, have you ever instructed this "expert" to provide
systematic follow-up on his or her recommendations? It might Le instructive for
you to ask tl1e adviser to compare the returns on his or her advice to the market's
performance duri11g the same period of time. The psychological need to perceive
166 Chapter 9: Common Investment Mistakes
goocl news may be insulating you and your hired experts from the trulh about
investing-and costing you a great cleal of money in the long run.
Plenty of external sources encourage investors' natural optimism. Financial
magazines remind us of the wise advice they provided in the past, but generally
neglect to mention the advice that was flat-out wrong. These publications also lencl
to supply anecdotal evidence of past success rather than risking their reputation by
tracking it in a systematic manner. Overall, we have to admit that this is a wise
business strategy: If they revealed the true returns on their past advice, they would
probably sell fewer magazines.
Denying that Random Events are Random
As we saw in Chapter 3, people tend to deny that random events are random and
find patterns where none exist, such as having a "hot hand" in basketbalL When
investors are led to believe that a specific fund is "hot," they will become more
willing to pay the fees associated with active investing. For example, when a funcl
outperforms the market two years in a row, investors rarely attribute its success to
random variation. It is more likely that they will overgeneralize from lhese few llata
points and assume that the manager of the fund has great skill and is therefore
worthy of their investment. As money manager N assirn :"Jicholas Taleb discusses in
his hook Fooled by Bandomness (2001), there is a great deal of randomness in the
iuvestment arena and even more denial of this randomness by investors and
investing professionals. In their eagerness to outperform the market, most inves-
tors are reluctant to settle for tl1e index fund strategy of performing at the level of
the market and minimizing expenses. The most important conclusion? Be wa1y of
any advice that predicts specific investments' future basecl on past performance.
Consistent with research by Bogle (1994), Carhart (1997), and Thaler and
DeBondt (1992), in the ten-year database used in tl1e Moore et al. (1999) study
(Hl8.S-1994), the performance of mutual funds tended to regress to the mean.
Nevertheless, stucly participants expected their portfolios' future performance lo
be highly correlated witl1 past performance. In fact, tl1eir expectations were
negatively correlated witl1 actual returns. Overall, pmticipants expected "hot"
funds to stay hot, just as they expect basketball players who are "hot" lo perform
especially well. Both of these expectations overestimate the influence of individual
skill and underestimate the role of cha.nee. This is the same false expectation that
leads real-world investors to hold on to expensive funds.
There is some minor evidence that past performance of stocks predicts their
future performance. Jegadeesh and Titman (1993) document a momentum effect
in which stocks that have clone well continue to do well the next year. The only
problem is that this pattern tl1en reverses itself in subsequent years (DeBondt &
Thaler, 198.S). Odean (1999) argues that liiased investors who expect past patterns
to continue in the future may influence a stock's performance. However, after the
last of these momentum traders enter tl1e market and push the value of tl1e stock
beyond the underlying value of the cumpany, the price will begin to fall, causing
the inevitable reversal.
The Psycholoay ,c p I
b OJ oar nvestment Decisions 167
DeBondt and Thiler (19 8.5) , d l
f . ' compare t le f t . 1'
o stocks: one group of extreme 1 -. f... I u me per orrnance of two grou1Js
l
- . ose1s iom tie l)ast thP . l
ex ieme wmners from tl1e IJa t tl . , . ee years anc one grcm1) of
5
uee years 1hey i cl tl . .
years, the "loser" IJOrtfolio clra . t' , II . - oun mt over the following five
D B d
ma ica y outrJerfo . . l I " . ,,
e on t and Thaler (198"') tt b i mel tie wumer IJOrtfolio
. .
0
a 11 ule reversals t tl , cl .
assume that the past is a good - d. , . f 1 o te ten ency of mvestors to
fo. b . . pie icto1 o l 1e future 1 cl t] I .
t ove1 uymg wmners and ove . JI I , 'n ms to t lell' penclnnt
. ' ise mg osers. The . I . '
ow11e1s of the under1Jriced "lo " . . r 1 . , . ma1 (et eventually adjusts and
se1 poi tw 10 will j d tl 1 '
mvestments than owners of tlie ove1 _. , 1 " . m ,,1emse ves with a better set of
Inspired by Jegadeesl d T'. 1J1,1cec wumer portfolio.
cl
1 an 1tman s (1993) . I .
a opt the strategy of bu . . , J esu ts, you imght be tem1Jted to
D
ymg iecent stock-market " .
eBoudt and Thaler' s ( 198.S) fi d. - vmne1 s. On the other hand
u r _ . .
111
mgs might rnotivat b '
111
01 lunately, it rs extreme! 1 lifY' , l _ . e you to uy recent losers.
I
) c ucu t to prechct wl tl I
rnve entered the market. Once a ain th . ien ie ast momentum buyers
future. Personally we are 11101-e gc ', e lb)last is not an accurate predictor of the
I
. ' ornwrh e ad 'tt' 1
mowmg which stocks will cl b . . . . . ' - ' mi mg t mt we have no way of
o ette1 m the future and sticking w1'tl . cl 1 d
l Ill ex un s.
Anchoring ti St t
' ie a us Quo, and Procrastination
Much of this chapter suggests that mm, . .
investments, trading stocl(s too f- '1 ) mvestors tlunk too much about their
1 equent y 1nd 1 1r -
most recent advice of too ' s l! mg mutual funds based on the
I . l . many experts. Evidenc I
l uu ( too little about the tYlie cif . t I e a so suggests that most peorJle
1
'1 . ki . asse s t iey wmt 111 tl . .
un ng tlirough one's asset 1ll t' cl ' lerr mvestment portfolios
_ ' , ' oca ion an <level , 1
gi eat deal of sense. This is wl1 . . " oprng a ong-term plan makes a
eie mvestment advi, (' I cl'
programs IJrovided by

t 1 r l ce. men mg free softwtre
l
=)'mu ua iunc co
1
. ) b '
S lefrin (2000), Belsky and Gilovich (1999) i 11lJames may e helpful. For example,
adv , , I , anc many otl1er SOl11-c 1 d fi
ice suggest t mt most l I es o goo unncial
peop e P ace loo little of tI . l . . ' '
stocks. This observation is base l tl l leu ,ong-tenn mvestments iu
b
', c on le ong-term s .- r
over onds and otl1er stanclt1- -j . upeuor penorrnance of stocks
. . . . ' c mvestments. Yet Jeo J] . ] .
asset allocation, sticking with I t 1 I l e use m1 y naive strategics for
_ l ! . . w m t iey or ot11ers have d" j ,d I .
WOJC s, t leir mvestmeut d cl eC1c e mt ie past m otl
1
er
ec1s10ns ten to be fair] niimll . '
In a study of scholars who enroll in r . . )' ess:
Beuartzi and Thaler (2001) f, l ]. plans oHered by TIAA-CHEF
. . . ounc t ut most IJrofessor [: , . . . ,
mvesting lheir retiremeiit i . cl . . l s, acmg a ch01ce between
un s m e1t 1er TIAA (b cl
co.1.nmonly allocated their money ""050 I on s) or CREF (stock),
l
. J .. to t ie two 1cc t I cld
mec
1
a11 m11nber of changes tl t .
1
. ' ouu s. n a ition the
. . . la pm essors made to tl . ll , . '
w,1s ze10. That is jH'ofessors ( .b . tl HS a ocati.on over their career
l b ' may e not . ie sma t t f l
cum est) made a fairly naive alloc ti' . cl 1, 'r es o peop e, but also not the
, l . . . a on an t len neve - d t, l l . . . .
even ,1s t ieir life c1rcumst l d I a JUS ec t le1J dec1s1011-
Tl . ances c iange over time
ie professors' .50:50 allocation meshes witl1 a . I .
(2001) findings: When firms ff . . l . . . 'not ler of Benartzi and Thaler's
, , , . l
0
ei a c 101ce of mvestment t' r _ .
accounts, t le percentage of stock funds ff, . . op ions i01 retirement
percenlage of dollars tl1at 1 101 e1ed is an excellent predictor of the
ernp oyees w1 ch t .
a company offers four fu11'ls tl l oose o mvest m stocks. That is if
c , iree stoc ( md
0
, L l l '
' nc uonc' cmp oyees put about
168 Chapter 9: Common Investment Mistakes
75 percent of their money into the stock funds. In contrast, if the company offers
one stock fund and three bond funds, then employees hold, on average, 75 percent
of their retirement investments in bonds. Thus, people choose their investments
the way many diners order food in a Chinese restaur:ml: one dish from the
"Vegetables" column, one from "Chicken," one from "Beef," and so on. Thal may
be a good way to pick a satisfying meal, but ifs not the best investment strategy;
history shows that if your money will remain invested in a retirement iund for
decades, stock funds will offer the best return. The point is that people should
think carefully about this allocation rather than being lecl naively by the choices
their employers offer them. . _ . .
By this point in the chapter, we hope that readers are recons1dermg their
investment decisions. However, there is a strong force competing against change:
the status-quo bias. This is the effect that prevented Benartzi and Thaler's (2001)
professors from rnaldng even one allocation change in a lifetime. Sarnuelson and
Zeckhauser (1988) find that people tend to keep their investments as they are. In
an experimental study, the researchers presented a exercise lo a group of
individuals willi a \Norking knowledge of economics and Jmance. The participants
were asked to imagine that they had inherited a large amount of money from
a great uncle and were asked which of four possible investments they would
(1) a stock with moderate risk, (2) a risky stock, (3) U.S. Treasmy 1,1lls,
and ( 4) municipal bonds. Each investment was described in a bit of detail. l'. our
other randomly selected groups were told that they had inherited irorn
their great uncle in the form of one of the four investrne:.1ts listed aliove. ( fhat 1s,
one group was told they inherited a stock with moderate nsk, a second group was
tokl they iuheritell a risky stock, a third group was told they mhented a U.S.
Treasury bill, and a fourth group was told they inherited a rnu111c1pal bond.)
These participants were asked whether they would keep the mveslment or trade
it for one of the three other investments listed abov:o. They overwhelrnmgly
chose to keep the investment they received rather than pickiug the
best suited to their unbiased preferences. Essentially, the study parhc1pauts
accepted the status quo rather than switching to the iuvestments that best suited
tbeir particular needs. .
Finally, the bias agaiust action also leads many people to procrastmate
making investments iu Lhe first place. Studies of automatic enrollrnent in 40l(k)
employee savings plans powerfully illustrate just how pass.1ve pe.ople can be
about very important economic decisions. 40l(k)s are 2.Ltract1ve savmgs velucles
not only because they defer taxation until the money is vvitbdrawn, but also
because some organizations offer to match the contrib1tions of their employees
up lo a certain amount. Most companies use an "opt-in" savings plan'. wlnch
means that their employees must enroll in the 40l(k) on their own 1rnliallve,
usually by filling out a form or calling a phone number. Others use
enrollment, where the default is enrollment at a set contnbut10n rate. In tins
scenario, an employee must make an extra effort if he or she does not want lo
contribute. The difference in employee enrollment rates between these two
different types of enrollment scheme:> is striking. Madrian and Shea (2001)
The Psychology of Poor- Investment Decisions 169
found that initial enrollments in 40l(k)s jumped from 49 percent to 86 percent
w1tlnn the same company when it switched from an opt-in system to automatic
emollrnent. Choi, Laibson, Madrian, and Metrick (200.3) found that a third
alternative called "110 defanlt," which forces the employee to think about the
dec1s1on, also increases enrollment, but not as much as automatic enrollment
(Choi et al., 2003)
. _Similarly, it is not uncommon for people to hold a large amount of money in
theu chedang, savmgs, or money market account with the intention of investinu it
soon. Months pass, and they find themselves facing the same
suddenly the market has gone up in value by 6 percent, and they've missed
ou_l on a great opportunity. By procrastinating, you may he sacrificing your long-
te1 m financial. well-bemg. Somewhat paradoxically, investors procrastinate on
malang allocat1011 decisions while being overly active in moving funds within a
category (e.g.,. stocks), thus putting too much effort into the less important
financial dec1s1ons and not enough effort into the far more vital ones.
Prospect Theory, Selling vVinncrs, and Keeping Losers
Odeau (1998) fouud that investors have a strong preference to hold on to stocks
that are selling below purchase price, so that they will avoid becoming "losers,"
and ,;o sell that are selling above the purchase price, so that they will come
out wmners. Srn11larly, Barber, Odcan, and Zheng (2005) show that investors
tend _to hold on to losing mutual funds and oversell winning mutual funds. If your
goal is_ to make as much money as you can, then the choice of whether to buy or
fund should be based solely on how much you expect its value to increase in
the 1uture. Thus, the price at which you bought it is an arbitrary and meaningless
reference pomt, except with regard to taxes. From a tax perspective, when you
sell a wmner, you must pay tax.es on your earnings, and when you sell a loser, your
taxes are reduced. Therelore, with respect lo taxation, it makes sense to sell more
losers than winners. Iu addition, Odean (1999) finds that the winners that
investors sell end up outperforming the losers that they keep. In sum, when
mveslors seek become winners, stock selectioh and taxes actually increase
their chances of being losers.
Calvet, Campbell, and Sodini (2009) have found that investors become more
eager to sell their winners as the performance of these i11vestrnents improves. Why
are mvestors biased to sell their winners? As we learned from prospect theory in
Chapter 3, dec1s1on makers tend lo compare outcomes to a reference point.
For most mvestors, the most common reference point is the price they initially
paid 1or a stock. Investors holding stocks valued at a price higher than they paid for
them are laced with a sure gain (selling now and becoming a "winner") or holding
the stock and nslang the current gain lor an unknown return. vVith gai11s, we tend
to be risk averse; investors tend to sell lo guarantee tlie gain. Investors holding
stocks valued lower than their initial purclrnse price, onL the other hand, must
choose between selling now-a sure loss-or holding the stock for an unknown
return. With losses, we tend to be risk seeking; investors tend to take the risk of
170 Chapter 9: Common Investment Mistakes
hol<liug on to the loser in the hope of becoming a winne: This is
consistent with a regret minimization strategy-that is, an effort to av01<l boolang
a loss and feeling regretful. As long as you let the loss "ri<le," you can pretend it
doesn't exist. Once you sell the stock, however, you have to enter it m your mental
accounts on the loss side of the ledger. This pattern lead:; investors to lose money
relative to the market's overall performance, for three reasons: the high costs
associated with making trades, selling the wrong stocks, an<l paying too much in
taxes. It also has other surprising implications, as BarLeris and Xiong
ing) have shown, including the fact that investors shuuld <lo more trndmg m
rising than falling markets, that individual investors will be drawn to volatile stocks,
and that these volatile stocks will wind up having lower average returns than
steadier stocks.
ACTIVE TRADING
Starting in the late 1990s, online trading became the growth area of the investment
world. Electronic trading was, and still is, simply cheaper than trading through a
stockbroker, and as more people began to trade online, the costs went clown. From
1996 to 1998, the average online trading commission fell by 75 percent. 111
addition, the Internet has enabled regular people to have access to a vast amount
of financial data, research, and tools, including up-to-elate :information, low-cost
trades and almost iustantaneous transactions.
First the good news about online trading: If you are planning to invest iu
stocks, bringing your costs down vvill be a key to your .succe.ss. So,. for
investors who follow a long-term buy-and-hold strategy, mvesting online rathe1
than through a full-service broker makes a great deal of sense. However, buy-and-
hold is not the strategy of the typical online trader. Especially dunng the late 1990s
bull market, online traders tended to be actively engaged in tradiug stocks. In the
worst case, they quit their joLs to be professional traders. Many of them were
headed for disaster.
The typical investor who engaged in online trading. around this time
someone whose trades had recently beat the market (most likely because theywere
lucky). In a 1992-1995 sample of online trading, BarLer and Odean (2002) lound
that the average new online traller outperformed the market by two
points the year before switching to online trading. Nole that these mveslors
confitlence was further bolstered by the fact that these were very good yea1 s io1 tl1e
stock market. Unfortunately, after switching, these traders' average performance
regressed to the mean and was further lowered by the costs of frequent trades. As a
result these online traders lagged the market by three percentage pomts.
r:agging a veiy successful market Ly three percentage points is no. disaster,
particularly if you engage in online trading in your tune. However, it was the
most overconfident traders who did lots of active tradrng onlme. Many oUhern qmt
their regular professions to trade full-time, becoming members of now
uotorious pseudo-profession called "daytrading." Under the. shict defimtion of
daytrading, individuals initiate and close out high-volume positions by the end ol
Action Steps 1 71
the same trading day, but the term refers to short-term trades in general.
Daytraders try to capitalize on price fluctuations of highly volatile, usually
technology-related, stocks.
The high frequency of their trades doomed these full-time traders to under-
perforrn the market by even more than three percentage points. Jordan and Diltz
(2003) studied records of 324 daytraders during 1998 and 1999, the time of an
umneuse slock market bubble, and found that only 36 percent made money during
llus heady penod. In adchtion, nearly all of these daytraders' profits were short-
term capital which were taxed as onlinmy iHcome (with a tax rate of up to .35
percent, dependmg on the investor's income bracket); more patient investors were
taxed on long-term gains at a much lower 1.5 percent Even before the market
plummeted, one particularly distraught Atlanta daytrader went on a shooting spree
after a streak of "bad luck" when the market went down, many more sacl stories
emerged about those who had quit their jobs and subsequently lost life savings by
daytracling.
"What caused reasonably smart people to decide to become daytraders? In
Chapter 3, we presented evidence that people respond to vivid data. Barber and
Odean (2000b) document the barrage of ads that made daytrading suceess stories
VtVId to Amencans. In one commercial, Discover Brokerage introduced us to an
mtnnsically motivated tow-truck driver with a postcard on his dashboard.
"Vacation?" . his white-collar passenger asks. "That's my home," the driver
responds. "Looks more like an island," comments the passenger The driver
explains, "Teclmically, ifs a country." Where did the driver get his wealth? Online
trading, of course-it was that easy. This type of commercial, as well as real-life
stories of the lucky, inspired more and more people to trade online, leading in
many cases to tragic consequences.
when Max used lo nm into daytraders (some were also taxi drivers), he liked
lo ask them why they thought they knew more than the party on the other side of
the trade. Most oi the daytraders Max met had never coHsidered this question.
When d1ey asked him to clarify, he tried to explain: When a daytrader is buying a
stock, it is because someone else lias sold it. Similarly, when a claytrader sells a
stock, som_eone else is buying it. Odds are that the other party is an institutional
mvestor of some s01t. Thus, most daytraders are typically paying fees to make an
exchange with someone who has better information, more experience, and quicker
hardware to make the trade than they do. Overall, we argue, this sounds like a bad
bet. But, as we saw in Chapter 4, people are not very good at considering the other
side of a transaction.
ACTION STEPS
lVlore than any other chapter in this book, the ideas presented in this chapter have
action implications for virtually all readers. vVe have reviewed the mistakes that
many people make and e1q1lained the psychology behiucl those mistakes. Now that
we have observed these mistakes iu the investing context, we close with some
specific thoughts to consider as you strive to reduce the biases that affect your
172 Chapter 9: Commun Investment Mistakes
investments. We begin with the issue o:: saving for retirement and close with
broader investment advice.
Determine Your Investment Goals
In Chapler l, 1Ne argued that a key aspect of making more rational decisions is lo
clearly identify your final goaL Many inve:;tors have never put much thought rnto
this issue. Some may have the goal of "accumulating as much money as possible."
But, if you are able to take this goal to the extreme-by earning a good income,
living frugally, and investing your savings wisely-you c::iuld end up dying with
mountains of money in your accounts. A different goal is to save what you need lo
buy what you need to live. This goal is the central theme of the investment
bestseller Die Broke (Pollan & Levine, l\J97) We have no objeclion to a mixed
strategy of buying the goods you desire and providing funds for other people and
charitable organizations. lfowever, many of us fail to think even this far ahead
about our monetary objectives.
The goal of investing to earn enougl1 for a comfortable retirement seems
straightforward. However, a 1997 survey found that only e percent of U.S. citizens
felt they had surpassed their retirement savings goal, while 55 percent felt that they
were behind ( Laibson, Repetlo, & Tobacrnan, 1998). Laib son et al. ( 1998) report
that the median U.S. household retires with liquid wealth of $10,000 and net worth
of $100,000 (including house equity and autos). This finding is consistent with a
broad array of evidence that Americam are saving too little for retirement.
Assuming that we are capable of saving more, why do we fail Lo do so?
the most direct answer comes from the want/should distinction developed m
Chapter 6. People know that they should save more for retirement, but wai.lt
to consume more now (to buy a new TV, eat dinners out, etc.). The evidence rn
Chapter 6 suggests that our desires typically overcome what we think we shoukl
do, particularly when the benefits of listening to our "should self' are decades in
the future.
U.S. tax policy and many employers provide incentives for people to save for
retirement. Because of these incentives, virtually all readers should be investing as
much money as they can to reduce their taxable income and maximize employer
matching contributions. If you are not contributing the maximum percentage of
your salary that your plan allows, then you are missing out 011 one of the.b.est and
safest ways to build your long-term wealth, Yet, among those who do participate m
40l(k) plans, most are contributing too little.
Once you have allocated money to :rnvings, decisions regarding where lo
place your retirement money should be based on a cle<ir asset allocation plan,
Benartzi and Thaler (2001) make a convincing case that most people have far
too low a percentage of their retirement fonds in stock. The fact that retirement
funding is for the distant future means that it should be easier to accept
the higher risk of stock in return for the higher returns that stocks acl11eve
over a long period of time. A few bad years are unlilely to. lead stocks lo
unclerperfonn bonds between now and the time most readers will retire. As you
Action Steps 173
approach retirement, it may make more sense to move more monev into bonds
to reduce risk. ,
, As retirement draws near, annuities also make a great deal of sense for those
mvestors who have the goal of buying a desired bundle of life goods. In return for a
lump sum of money, the investor gets a guaranteed amount of fonds periodically
for the oflus or her life. ff you die ahead of schedule, you lose-but then again,
you wont need the money anyway. However, if you outlive expectations, you can
get a great return, and you are more likely lo need these additional funds,
Annuities are underused in comparison to the financial benefits that they create,
In adcht1011, an11mt1es are now provided by a number of eharitable organizations,
allowmg you to obtain guarauleed income and tax benefits and to fund your
prelcrred charity. These annuities ereate more total benefit thaH you could achieve
pnvately wlule making a similarly valued contribution to society. Although
are log1eal for mauy investors, you need lo choose them carefully.
Some annmties, pushed by the sleaziest outfits in the financial business, come
wilh a slick sales piteh and are wildly overpriced. "'e recommend sticking with a
lughly reputable, well-known mutual-fund family that charges low fees, such as T.
Rowe Price, Sehwab, or Vauguard.
Beyond retirement: the key argument of this chapter is thal very bright people
are cuneutly paymg lnllions of dollars per year for collectively useless advice.
Why? Bee<'.use they are cornmitling the errors described throughout this book in
the area of investing.
Why is the Slock ,Market: so Difficult to Predict?
Even smart people have trouble correctly predicting changes in the stock market,
p,robably lots of other smart people arc trying to do the exact same thing.
1 he econonust J olm Maynard Keynes highlighted the situation with a famous
analogy (1936, p, 15G):
Professional investment may Le likened lo those newspaper competitions in which
the competitors have lo pick out the six prettiest faces from a hundred photo-
graphs, the prize being awarded to the competitor whose choice most nearly
corresponds to the average preferences oflhe competitors as a whole; so that each
competitor has lo pick uot those faces which he himself finds prettiest, but those
which he thinks likeliest to catch the fancy of the other competitors, all of whom
are looking al the problem from the same point of view. It is not a case of choosing
those wluch, to tl1e Lest of one's judgment, are really the prettiest, nor eveu those
which average opinion genuinely thinks the prettiest v\/e have reachecl the third
degree where we devote our intelligences to anticipating what average opinion
expects the average opinion lo be. And there are some, I Lelieve, who practice the
fourth, fifth and higher degrees.
To predict whieh stocks will rise, investors Heed Lo know which stocks
other investors think will rise, just as those other investors are trying to do the
same. Of course, if everyone stopped playing this game, gave up hope that they
174 Chapter 9: Common Investment Mistakes
could beat the market, and invested solely in passive index funds, then there
might be a chance for a veiy small number of well-informed investors to exploit
their knowledgeo But there is no prospect of that happening any time soon,
thanks to investors' enduring faith in their ability to pick investments that will
beat the rnarkeL
Putting This Chapter lo Use
Now that you understand the psychology behind investment mistakes, you
must learn to confront them and identify a better strategy for the futureo
This strategy should include taking the time to formulate an asset allocation
piano You should strive to achieve this allocation in a low-cost manner; avoid
paying fees to people and companies who do not truly add valueo \ ~ h i l e many
investors now know to avoid "loads" (commissions paid when you buy a mutual
fond), far too many are still buying funds with ve1y high annual expense ratios
(Barber et aL, 2005)0 Once you have your plan in place, continue to invest on a
regular basiso If you combine these three tasks-appropriate asset allocation,
low-cost investing, and adding regular investments-you are well on your way to
an excellent investment strategyo Then relax and go back to tasks that you enjoy,
be it playing tennis, playing with your kids, or traveling the world-there is little
reason to be thinking about your investments more than a few hours per yeaL
The advice in this chapter is consistent with that offored by Burton Malkicl
(2003)0 Readers interested in more information and more detailed recommenda-
tions ou investment, including helpful suggestions for portfolio allocation, should
consider reading his clear-sighted and informative book A Random Valle down
Wall Streeto
We should also offer some final words of caution: Changing your allocation
of funds according to the advice in this chapter does reqtjre some care, as it can
have lcL'{ irnplicationso Before selling securities that have appreciated in value,
you must first seek to understand the taxable consequences of doing so; you may
want to check with your accountant The advice in this chapter is relevaut to
existing investments, but must be applied to them with careo It should Le easiest
to follow our advice when you are thinking about making new investmcntso