Wealth maximization versus the economics of survival

The term ‘behavioral economics’ is relatively new, and its work is often thought to have started in 1979 following a paper titled “Prospect Theory” published by two psychologists. Yet human emotion, and the ‘human factor’ in economic decision-making, can often be seen as an explanation for the Great Depression, showing that psychology has been used to explain economics for quite some time. Technically, however, the study of psychology and economics – behavioral economics – can be traced back to Adam Smith and the 18th century. Adam Smith was one of the first economists to refer to the proposed choice asymmetry between losses and gains in wealth.

The Theory of Moral Sentiments by Adam Smith (page 213):

We suffer more, it has already been observed, when we fall from a better to a worse situation, than we ever enjoy when we rise from a worse to a better. Security, therefore, is the first and the principal object of prudence. It is averse to expose our health, our fortune, our rank, or reputation, to any sort of hazard. It is rather cautious than enterprising, and more anxious to preserve the advantages which we already possess, than forward to prompt us to the acquisition of still greater advantages.

Adam Smith’s essay, published in 1759, explains a question that I believe is the basis of behavioral and experimental economics: the question of wealth maximization versus the economics of survival, and their different implications for behavior. Markets cannot be rational if users are not fully rational. When users are forced with the option of wealth or survival, irrational decisions are often made. Would your spending habits change if you were diagnosed with a deadly disease? Would your investment strategy adjust if it were assumed that you would survive forever? Studies have shown that firms (and individuals) that maximize profits are the least likely to be market survivors (3). But what if you do not want to be a survivor, but rather a wealth maximizer? Case-in-point: rational behavior cannot be defined, and your idea of rational may not be the ‘right model’ of rational behavior.

Supporting of the Adam Smith quote above, irrational behavior is most often noted during a downfall. Consider Facebook (FB) who recently surpassed – after one year of trading - their pre-market IPO price. Those who invested in FB made a rational decision: they paid $38 a share. However, as news headlines questioned their rationality (2), many made an irrational decision to sell, buy or hold. Some held even though their ‘rational’ said no because they were anchored to the $38 IPO price; some sold although their ‘rational’ initially believed that the company was worth its selling price today of $45; and some bought although their ‘rational’ initially said the company was a flop. In summary, ‘rational behavior’ is ill defined considering everyone has a different goal and outlook on life. There are many other examples in which people did not act in ways to best suit their needs, but rather got stuck because the numbers did not match (1). For example, consider the recent rise in mutual and index fund investors over the last year due to the surge in US markets; consider the homebuyers prior to the Global Financial Crises who, amongst many other reason, signed considerably generous loans because ‘times were good.’

Irrational behavior is common when it comes to consumer spending as well. Considering I have already wrote a lot more than what is necessary for a discussion board, I will not drift into another subject and turn this into an essay. However, look at the following marketing research recently published by the USF College of Business (4):

1.  If there is a situation with a monetary prepayment, consumers will likely spend more. For example, if a person is charged a cover charge to get into a bar, he will spend more money on drinks to make up for the fact that he paid to get into the establishment.

2.  If consumers are forced to make a significant effort prior to a purchase decision, they will be apt to, again, spend more money. An example of this would be if a person left his ID card in the car and had to retrieve it to gain entrance into the movies, he would spend more money at the concession stand to compensate for his efforts.

3.  If consumers make a considerable time investment to spend, they will be inclined to over-consume and over-indulge. For instance, if a person has to wait in a long drive-thru line at a fast-food restaurant, he will buy more food than he had originally intended to offset the time he invested waiting.


References posted below:

(1) http://bucks.blogs.nytimes.com/2012/08/27/dont-let-the-original-price-haunt-your-decision-to-sell/?_r=0
(2) http://www.mercurynews.com/business/ci_21354225/facebook-shares-hit-all-time-low-fall-less-half-ipo
(3) Smith, V. L. (2005). Behavioral economics research and the foundations of economics. The Journal of Socio-Economics, 34(2), 135-150. doi:http://dx.doi.org/10.1016/j.socec.2004.09.003
(4) http://www.businessobserverfl.com/press/detail/consumers-behave-irrationally-when-it-comes-to-financial-decision-making/

Caveat Emptor: let the buyer beware

I have been slowly but surely reading “Manias, Panics, and Crashes: A History of Financial Crises” by Charles P. Kindleberger and Robert Z. Aliber.  Coincidently, I am on Chapter 7, which covers frauds, swindles, the credit cycle, and Bernie Madoff.  In the book the authors ask a commonly asked question: should the governmental authorities establish ‘truth police’ to prevent the investing public from being misled, or should the public be on its own in determining which statements made by the stock sales personnel are not strictly true (1)?

One of my initial reactions when trying to answer a question as such is usually something along the lines of “who should determine what is right and wrong?”  While the implosion of a financial bubble always leads to the discovery of fraud, to include our most recent financial crises, a majority also points to acceptance of caveat emptor, which is Latin for “let the buyer beware.”  Nevertheless, most fraudulent behavior is illegal, but most can linger on an ill-defined and vague legal borderline.  Some of those ‘fuzzy’ activities may be entirely legal, yet those engaged in them would be unwilling to have their activities posted on the front page of the Wall Street Journal or Financial Times.

I believe a touch of caveat emptor will always be present in the financial industry – as it should!  However, regulation must also exist in order to ensure buyers and sellers buy and sell based on their own idea of risk and personal knowledge, not on the possibility of illegal behavior.  As discussed previously in this course, sovereign risk and protecting investors is a major factor in economic development and future investment.

What can we do to increase investor confidence and ensure accurate information is released?  I believe SOX regulations need to be intensified to include mandatory audit firm rotation.  SOX currently requires that companies rotate their audit partners every 5 years, however, there is no regulation on the rotation of the firm.  According to GAO Analytics, nearly 35% of companies in the S&P 500 have had the same audit firm for 25 years or more, about 60% of audit firm tenures for Fortune 1000 companies are estimated to be 10 years or more, and 8 companies in the Russell 1000 have not changed auditors in the last 100 years (3).

In addition, many audit firms also offer consulting and financial advisory services.  Undoubtedly, helping companies make money can be in conflict with auditing – remember the Big 5?  Deloitte, the largest audit firm in the world, grew 8.6% in 2012.  Deloitte increased revenues from consulting by 13.5% and from financial advisory by 15% (4).  CEO of Deloitte Barry Salzburg said that they are adding consulting staff at twice the rate as audit employees, and that he expects consulting to continue to grow by double digits (3).  Keep in mind: at this rate the firm would do more consulting than auditing by 2017.

Lawmaking bodies have brought up the idea of auditor rotation.  Still, the last vote on mandatory auditor rotation was shot down 321-62 for HR 1564 (5).  Should the above be stopped?  Are public accounting firms working in the best interest of the public?  Do you think mandatory audit firm rotation will help?  How about the implementation of audit-only firms?

References

(1) Manias, Panics, and Crashes by Charles P. Kindleberger and Robert Z. Aliber
(2) http://www.merriam-webster.com/dictionary/caveat%20emptor
(3) http://www.directorship.com/mandatory-audit-firm-rotation-explaining-the-key-numbers/
(4) http://www.economist.com/node/21563726
(5) http://www.forbes.com/sites/francinemckenna/2013/07/09/house-counts-on-honor-amongst-thieves-votes-against-mandatory-auditor-rotation/