Rational stupidity

It can be quite rational to behave stupidly. That’s the claim of this new paper (pdf) by Anne Sibert and Hamid Sabourian - which might explain why highly paid bankers made such a horrible mess.
To see what they mean, start from the premise that bankers are paid not by results, but by perceived competence.
Now, put yourself in the position of a banker who has gone long of mortgage derivatives - toxic assets, to use a phrase I hate -  in the belief that the US housing market will continue to boom. You then get a signal that the boom might turn to bust. What do you do?
The obvious thing is to sell your position. But this might not be rational. If you do this, you incur a certain loss. Your bosses think: “Hey, this guy doesn’t know what he’s doing. One moment he tells us to go long of CDOs, the next he’s selling. We don’t need to give this putz a big bonus; who’d be daft enough to hire him?” This certain loss is offset by only a possible gain - the possibility that the market really will bust before the bonus season.
The desire to appear competent - to stick with your previous position - can therefore lead rational people to stick with assets that may well lose money. This happens because our trader is concerned to maintain his reputation, as this determines his salary. Indeed, say Sibert and Sabourian:

It is possible for all experts to continue to predict an event that they know is virtually certain not to occur.

Worse still, the better our trader has been in the past, the more likely he is to be wrong. This is because his response to signs that his original position might be mistaken would be: “There are always noisy signals that I might be mistaken. I’ve been right to ignore them in the past. What’s different now?” As Sibert and Sabourian say: “more competent experts do not necessarily make better predictions.”
There are, at least, two takeaways here. First, bad incentives can cause rational people to look as if they are acting stupidly. To an outsider, our trader looks like he’s committing some combination of the confirmation bias or over-confidence. But in fact, he’s acting rationally, maximizing his expected utility.
It’s not, of course, just in banks where this problem arises. Politicians might stick with bad policies, because the cost of doing a “U-turn” and signalling incompetence would outweigh the benefit of adopting the right policy.
Second, all this might explain why it is banks, rather than hedge funds, who have suffered most. In both, payment depends partly upon actual results and partly upon perceived competence. But in banks, it’s the latter that is (a little?) more important. And the desire to preserve perceived competence might have led to rational irrational behaviour.

Comments

[kinglear]

Personally, I have long believed in the cock-up theory of humanity - if something can be a cock-up, it will be. I think this is a long standing position -during the last war people referred to things being SNAFU.
Situation Normal All Fouled Up

[Mark]

The great George Polya made an important related point. He said that mathematicians and scientists instinctively looked for cases that disproved their theories while other people tended to look for cases that confirmed them.

This raises some interesting questions about how we should classify economists.

Mark
daddywhatsarepublican.blogspot.com

[dirigible]

"bad incentives can cause rational people to look as if they are acting stupidly."

They look like it because they are.

Near-perfect functional equivalents of stupidity are not phantasmagorical epiphenomena generated by the behaviour of mis-incentivised really smart people. They are the desired outcome.

There are no non-perverse economic incentives.

[sean]

So in short the Stupid party are the most rational party to vote for at the next election?

"The desire to appear competent - to stick with your previous position" that would be all those voting for the materialist left?

As I wrote on the Yards blog "Its interesting that the bankers are in the dog house for taking too many risks, the lobby are in the dog house for taking too little"

[Attorney Wright]

"The desire to appear competent - to stick with your previous position"

This often occurs in the civil litigation field. Clients tend to mistake consistency with competency. Thus, in order to appear competent , attorneys are forced to stick with their initial litigation strategies regardless how the facts or law have subsequently changed. This is an irrational strategy if you want to win the lawsuit. However, it is a rational strategy if you want to keep the client.

And this is not just limited to laypersons unfamailair with the legal process.

I have worked with insurance adjusters for over 24 years. 70% of them are great. Another 30% stink. Why do they stink? Because they cannot conceive how a competent attorney could ever change his / her initial conclusions, regardless how significantly the facts or law have changed. If you want to continue to get work from these adjusters, you better not deviate one inch from your initial case assessement. If you do, you'll never see any further work. That is why every so often you'll see a bright, smart, hard-working attorney try a case based on a horrific legal theory totally inapproriate for the case.

[M.G. in Progress]

There is another aspect between stupidity and incompetence: it's negligence. Basically people do not care as long as they can gos back home and sleep comfortably.
For more see my Social norms versus market norms: how to screw the economy up
at
http://mgiannini.blogspot.com/2009/03/social-norms-versus-market-norms-how-to.html

[ad]

"George Polya ... said that mathematicians and scientists instinctively looked for cases that disproved their theories while other people tended to look for cases that confirmed them."

A cynic would say that scientists look for cases that disprove rivals of their theories.

[Rocio]

estan muy interesantes los temas felicidades.
http://rsepuesta-rapida.net

[Steve]

Absolutely I agree. Some smart people pretends to be always 'smart', that's why they are not making any right calls! This results in total collapse as happened recently in the U.S housing market.
http://www.paydayonly.co.uk/

[Rowland]

Malcolm Gladwell makes a similiar point. He says that the incentives to seem that you know what you're doing mean that confidence almost always turns into over-confidence.

http://www.rowlandmanthorpe.com/blog/2009/05/great-confidence-disasters/

[dindigul]

well, smart people always work smartly. but some of the people who is in lazy wants incentives for do their work.
giving incentives is one of the HR-tool for motivation

[Tag Heuer]

And a lot of it reflects a switch from bank deposits to securities; foreigners “other investments” in the UK, http://www.watchgy.com/ mostly bank deposits, fell by £143.2bn in Q1. And of course there’s no guarantee such buying will continue.
http://www.watchgy.com/tag-heuer-c-24.html
http://www.watchgy.com/rolex-submariner-c-8.html

[Frank]

Great points on here. I think it's always best to have someone to back up another persons thoughts... or knock them back.

[Frank]

Unfortunately there will always be stupid people...
http://www.hourpaydayloans.co.uk/quick_cash.aspx