Major crises are fertile grounds for leaders intent on studying human failure at a grand scale. The financial mayhem that engulfed the globe and failure of solutions can be explained by the deficient mental habits of individuals. Without sufficient checks and balances, their fallacious thinking remained uncorrected, engendering suboptimal action at the aggregate. Worse, some Machiavellians exploited the predicable weaknesses of humans in order to sway them.
In the complex capitalist system with its manifold interdependencies, reinforcing loops potentiated errors. To cure problems at their roots before a domino effect makes them too large to be solved easily, leaders should watch out for the following systematic mental distortions, which are often interrelated (see illustration).
1. Lack of cyclical reasoning
People routinely fail to draw inferences from the simple but consequential empirical tendency of things to move in cycles -- what goes up can be expected to go down and vice versa; integration and disintegration alternate. The Asian "miracle" ended in the 1997 IMF crisis and the dot-com bubble exploded. Then, recovery ensued.
This time round, many investors incorrectly believed that rapid economic growth and spectacular increases in share prices would continue indefinitely, overlooking the statistical regularity for booms to be followed by busts.
Failure to engage in regressive thinking, whose expediency rises as uncertainty mounts, is partly due to the mental habit of overemphasizing the specific details of an individual case. People come up with complex tailor-made explanations when encountering shifts away from outliers. Unfortunately, they commit the biggest mistakes when predicting either very high or unusually low performance, making them unready for extreme outcomes.
Investors failed to adjust for small sample size. They uncritically accepted the similar stories of a few outspoken "experts" who by far outnumbered people featured in the media with other opinions. Because the sample was tiny, the former were likely to hold extreme views though. Nevertheless, their halos persuaded the audience that fundamentals had changed for good. Investors believed that financial innovations such as structured financing defied gravity and mortgages with minimal down payments extended to consumers with very low earning power were sound. The labels that respected rating agencies attached to securities misled naive market participants. In benign cases, bankers simply suffered from the "curse of knowledge". Unable to imagine that many ordinary investors cannot assess risk properly, the specialists sold them products that harmed them.
Investors succumbed to representativeness bias, concluding that observed facts fitted the compelling "bright new world" theory. They misconceived chance and believed in self-correction, thus underrating the likelihood of "bad streaks". Trusting in their "hot hand", they continued investing in risky assets. Wishful thinking engendered selective perception; people subjectively validated only what accorded with their desires.
Investors fell prey to availability bias, assigning more weight to the easily recallable sound bites of optimistic gurus that the media repeated incessantly. Analogies of bubble bursts could not be easily retrieved inside companies that had not indexed the knowledge of market veterans. People assumed correlations based on the observed frequency of media covering spectacular successes. Thus, they did not bother to look for evidence disconfirming the false belief that high risk always leads to high returns.
After the market slump, the banking lobby exploited vividness bias, the tendency to be swayed by striking features, with a parade of horribles. Amid much ballyhoo, financiers who had preached the free market gospel warned the global economy would be destroyed if governments did not step in immediately. The isolation effect increased the saliency of the message. The mainstream media eschewed alternative scenarios, such as Asia counterbalancing U.S. shocks.
The plausibility of imminent doom remained unquestioned, since the lobby banked on the conjunction fallacy. People overestimate the likelihood of complex events with simultaneously occurring seemingly representative features. Enlightened investors would have realized that a simultaneous meltdown on all continents across all industries is not very probable, because some forces neutralize each other. It emphatically is less likely than mayhem only in one province, which however appears less representative to people recently primed in chaos. Misconceiving disjunctive events, investors underestimated the likelihood of complex systems faltering; they will not surmise that the proposed complex solutions can easily fail for "want of a nail".
2. Compartmentalized preferences
Mental accounting treats cash streams differently although they are fungible. Policy-makers implicitly differentiated costs depending on who had to bear them. Using bailouts, they spared wealthy executives and depositors, while burdening shareholders, taxpayers and future generations.
Humans engage in "hyperbolic discounting", preferring instant gratification over future rewards and delaying pain as long as possible. Not surprisingly, impulsive consumers jumped on mortgages with low down payments.
3. Cognitive immobility
Using mental accounting, people treat equal gains and losses differently. This gives rise to the endowment effect of valuing things more when you own them. Many prefer the status quo and do not part with assets, since they are particularly reluctant to realize "losses" from lower market estimates. Thus, bankers failed to liquidate subprime mortgages.
People often escalate commitments. Refusing to write off sunk costs, they throw good money after bad. Bankers dramatically increased exposure to toxic assets and politicians inflated rescue packages. Both shifted anchors while the public accepted the misleading new reference points -- now a trillion dollar rescue package appears normal.
Overconfidence reinforces escalation, since it prompts people to cling to their favorite approach. Most investors believe they can outsmart the market, although on average this is impossible.
Politicians usually trust they can control things and suffer from "cognitive dissonance" when observing their powerlessness. One solution is to stick to the self-image and shape reality through "game-shifting" action.
Hindsight bias, the incorrect belief in having foreseen events (such as the financial crisis) results from overconfidence. Self-deception prevents people from realizing their cognitive shortcomings and increases rigidity.
4. Collective infections
Many people jump the bandwagon, jubilating and panicking with the crowd. Group decision-making diffuses responsibility. No wonder the EU dared to distribute blank checks to large financial institutions by promising that none will be allowed to fail and guaranteeing all interbank loans.
Psychological analysis elucidates the reasons for the global economic crisis and failure of solutions. Knowledge of mental distortions that engender irrational decisions helps the reckless exploit the weak but also strengthens David, the ordinary citizen, in his fight against the financial Goliath.
"Prof. Kai on Strategic Leadership" Column Number 11. Kai-Alexander Schlevogt (D.Phil. Oxford) is a professor of strategy and leadership at the National University of Singapore (NUS) Business School and author of The Art of Chinese Management (Oxford University Press). Email: schlevogt@schlevogt.com; website: www.schlevogt.com.
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