Behavioral Finance and Economics - Hingsight Bias - Knew or Should Have Known

Recently I testified as an expert witness in an arbitration involving retail stock-brokerage activity.  My client asked that I attend the hearing and observe the testimony of the other witnesses as a prelude to my testimony.  In doing so I was constantly reminded of the cognitive distortion called Hindsight Bias and an Observation I wrote several years ago as an in-house counsel.  I reproduce that piece:

·        Hindsight Bias Revisited

Hindsight bias: The natural tendency of an individual to overweight the probability that an event would occur after being told that the event had occurred.

The most common allegation I see in an arbitration is "knew or should have known."  Often the resolution of "should have known" is the deciding issue.  Its resolution also involves the involuntary and subconscious application of the principle of "Hindsight Bias" by arbitration panel members.

When you judge risk about the future, you judge it with foresight and objectively. When panel members judge risk, they judge it with hindsight and not so objectively (using Hindsight Bias).

Panel members are effectively asked to step back into the past and through the use of their imagination attempt to the judge probability of something occurring (in the then future) when they already know "it" did occur. In their attempt, try as they might not to, they may overweight the probability.

You may wish to keep the foregoing  in mind while managing your risks. 

  -10/30/2006

Don't Stop Managing Your Risk Just Because You Have a Dispute

“I was never ruined but twice - once when I lost a lawsuit, once when I won one.”

                                                      -Voltaire

I write these Observations to help you manage your risks as intelligently as possible.  Nevertheless sometimes problems and disputes over those problems arise.

So when you have a dispute over a problem don't you want to control its outcome (i.e. manage that risk as well)?* 

When your dispute ends up in litigation or arbitration and you finally turn it over to the arbitration panel or jury to decide you, at that point, give up total control over your fate.  Think about potential panel or jury members and how well you will know them. Why would you give up that degree of control over the resolution of your dispute to total strangers? Here is a link to a recent federal appellate court decision which I think dramatically tells us what unforeseen events may occur once we do turn over that control (in this case at least three times).  I do not cite this case for any proposition other than the line from the movie Forrest Gump "You never know what you're gonna get." Now for the link: 

http://pacer.ca4.uscourts.gov/opinion.pdf/091038.P.pdf *

Think about about mediation, you do, after all, retain control during the entire process. You are not alone in controlling the outcome but then you never are in arbitration or litigation. When you are mediating a dispute you are actively managing your risk.  Not so in the other forums - as I said when your evidence is in and the arguments are over and you turn your case over to a panel, judge or jury all risk management ceases. You better hope that a good jury, judge or panel showed up for your case and the bad ones somehow went to a case on the other coast.

* my thanks to my acquaintance Marc Dobin, a securities lawyer in Jupiter Florida, for a recent blog post which alerted me to this case. Marc's blog can be found at http://lawyersfromjupiter.blogspot.com/

Behavioral Finance and Economics - Reciprocal Altruism and Homo Economicus

“Economic Humankind” is, according to classic economic theory, made up of individuals who possess the attributes of unbounded (1) free will, (2) self-interest and (3) rationality.  I reserve for another day an Observation on “unbounded rationality” and today take a short look at the concept in classical economic theory that we are selfish and self maximizing (unbounded self-interest).  Dr. Michael Shermer, in his book The Mind of the Market: Compassionate Apes, Competitive Humans and Other Tales from Evolutionary Economics, describes the moral emotion of “reciprocal altruism” or “I will scratch your back if your scratch mine” – to which I politely add, “or if not take a hike.”  This moral sense of fairness is hard wired into our brains and according to Dr. Shermer, present in all humans and primates tested for it.  It was developed during our formative years as “hunter-gathers” as a means of self preservation of the tribe but has continued to exist even now that we, in the words of Dr. Shermer, have morphed into “consumer-traders” in a large society. As I stated this reciprocal altruism trait has been repeatedly confirmed, more specifically, in a test dubbed the “Ultimatum Game” by behavioral economists.  In the game participants are paired up and one of each pair is given $100 with a condition.  That person is ordered to propose a split of the funds between her/himself and their game partner. If a proposal to split the money in a particular fashion is accepted by the partner then each get their agreed upon proportion.  If the proposal is not accepted then neither gets any portion.

Classical economic theory would tell us that no matter what the proposal is (assuming it was not 100 to zero) the trading partner will, without exception, accept.  The reasoning is that the partner is a Homo Economicus and will not turn down free money (no matter how small or disproportionate the share).
Results of the game in operation show that anything less than a 70 -30 split is usually rejected.  You are not surprised.  Now why would that be?  Well no doubt you have concluded that less than a 70-30 split is not viewed as fair.  No kidding. But although fairness is not a concept in classic economic theory - it is in human psychology - the moral emotion of “reciprocal altruism.” See your conclusion is really the operation of this trait and by the way it’s a reflexive action not a reflective one which once again means it’s invocation is subconscious and compulsive (don’t know it and can’t help it).

You may wish to consider the foregoing as further evidence that psychology matters when analyzing how an investor may confront economic dilemma. In addition you may wish to consider whether something you did or propose will be analyzed by others as being fair and if it’s not whether the moral emotion of reciprocal altruism will have an effect on the evaluation of your proposal (or historical action)*.
*For those of you in the dispute resolution business I bet you can see several important implications.
As a postscript today I thought I would give you the following link to Paul Krugman’s article in a Sunday edition of the New York times.   http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&em