Long-term gains are substantial after bear markets

InvestmentNews

By Andrew Coen
September 15, 2008, 6:01 AM EST

If the past is any indication of the future, investors should not panic and sell their stocks because of the current downturn, according to a new study.

There have been 12 bear market cycles in the last 60 years, and investors who held on to investments during each of those instances made gains in the long run, according to the new report based on quantitative data issued by Boston-based Putnam Investments.

Since 1948, there have been 12 bear markets that lasted an average of 14 months and saw an average decline of 22.4% in the Standard & Poor's 500 stock index. After each of those, economic conditions improved, with 12 bull market occurrences lasting an average of 45 months and seeing an average 123.9% gain in the S&P 500. ...

In addition to calming their panic, Scott Toms, chief investment officer at Hagerstown, Md.-based Cornerstone Wealth Management Group, urges clients to diversify and to be prudent when investing in large cap offerings, because losses may be greater.

"You can really miss big moves in the market if you get out," said Mr. Toms, whose firm manages around $150 million in assets and is licensed through Boston-based LPL Financial. "We try to stay invested in various asset classes."

Keith Newcomb, a wealth manager at hourly fee-based firm Full Life Financial LLC of Nashville, Tenn., is skeptical about the Putnam study's findings because, he argues, investment strategies need to be geared toward a client's individual lifestyle and not based on 60-year data.

"The sequence of returns is so much more important than the conclusion drawn from a 60-year period," said Mr. Newcomb. "Advisers and clients should have a strategy in place to prevent runaway losses in some sectors, [which happened to some] during the last bear market."

E-mail Andrew Coen at acoen@investmentnews.com.

More companies are using game theory to aid decision-making. How well does it work in the real world?

CFO Magazine - July/August 2008 Issue

Alan Rappeport - CFO Magazine

July 15, 2008

When Microsoft announced its intention to acquire Yahoo last February, the software giant knew the struggling search firm would not come easily into the fold. But Microsoft had anticipated the eventual minuet of offer and counteroffer five months before its announcement, thanks to the powers of game theory.

A mathematical method of analyzing game-playing strategies, game theory is catching on with corporate planners, enabling them to test their moves against the possible responses of their competitors. Its origins trace as far back as The Art of War, the unlikely management best-seller penned 2,500 years ago by the Chinese general Sun Tzu. ...

... One popular way to teach the theory hinges on a situation called the "prisoner's dilemma," where the fate of two detainees depends on whether each snitches or stays silent about an alleged crime (see "To Squeal or Not to Squeal?" at the end of this article).

...[Oil] giant Chevron makes no bones about it. "Game theory is our secret strategic weapon," says Frank Koch, a Chevron decision analyst. Koch has publicly discussed Chevron's use of game theory to predict how foreign governments and competitors will react when the company embarks on international projects. "It reveals the win-win and gives you the ability to more easily play out where things might lead," he says.

Enter the Matrix
Microsoft's interest in game theory was piqued by the disclosure that IBM was using the method ... (Consultants note that companies often bone up on game theory when they find out that competitors are already using it.)

For its Yahoo bid, Microsoft hired Open Options, a consultancy, to model the merger and plot a possible course for the transaction. ... "We knew that they would not be particularly interested in the acquisition," says Ken Headrick, product and marketing director of Microsoft's Canadian online division, MSN. And, indeed, they weren't; the bid ultimately failed and a subsequent partial acquisition offer was abandoned in June.

...To simplify complex playing fields, Open Options uses algorithms to model what action a company should take — considering the likely actions of others — to attain its goals. The result replicates the so-called Nash equilibrium, first proposed by John Forbes Nash, the Nobel prize–winning mathematician portrayed in the movie A Beautiful Mind. In this optimal state, the theory goes, a player no longer has an incentive to change his position.

As a tool, game theory can be useful in many areas of finance, particularly when decisions require both economic and strategic considerations. "CFOs welcome this because it takes into account financial inputs and blends them with nonfinancial inputs," says Tom Mitchell, CEO of Open Options.

Rational to a Fault?
Some experts, however, question game theory's usefulness in the real world. They say ... it assumes that all participants in a game will behave rationally. But as research in behavioral finance and economics has shown, common psychological biases can easily produce irrational decisions.

Similarly, John Horn, a consultant at McKinsey, argues that game theory gives people too much credit. "Game theory assumes rationally maximizing competitors, who understand everything that you're doing and what they can do," says Horn. "That's not how people actually behave." ... McKinsey's latest survey on competitive behavior found that companies tend to ... [rely] passively on sources such as the news and annual reports. And when they learn of new threats, they tend to react in the most obvious way, focusing on near-term metrics such as earnings and market share.

When trying to untangle the cases of past disasters, have you ever noticed that somewhere in the chain of events, someone made an irrational decision? Most risk managers will attest that people make bad, silly and crazy decisions from time to time.

Risk & Insurance May 1, 2008

By Beaumont Vance

When studying economic theory, one learns early on about the concept of the "rational man." The idea is that in any market economy, decisions are made based on rationality. ...

Many people take the rational man concept quite seriously. It has been an almost unquestioned concept for much of the past 100 years. But recently, some have actively questioned it. ...

... In the 1970s, two professors, Daniel Kahneman and Amos Tversky, decided to test just how rational people are when making decisions involving risk. They conducted an enormous number of studies that show that, most of the time, people make decisions that are demonstrably irrational. In 2003, Kahneman was awarded the Nobel Memorial Prize in Economic Sciences for this work. (Amos Tversky had passed away by the time of the award.)

The work of Kahneman and Tversky did change the science of economics. It even spawned a new field called behavioral economics. Unfortunately, it has not been widely adopted within the discipline of risk management. ...

The dominant driver of risk is human behavior. ...

While people might be irrational, they are at least predictable in this irrationality. Kahneman and Tversky provided numerous studies that demonstrate exactly when and how people will become overly risk averse or choose to take too much risk. A 1979 study even shows when and how people will choose deductibles over quota-share coverage. It would be nice if the practical ideas of Kahneman and Tversky displaced the less useful concept of the "rational man."

BEAUMONT VANCE is the risk management columnist for Risk & Insurance®. He manages risk for a leading financial company.

May 1, 2008

Copyright 2008© LRP Publications

Computerworld

In IT, influencing those over whom you have no authority is the key to success. Here's a strategy for doing it.

David Maxfield

October 15, 2007 (Computerworld) -- ...If influence is the capacity to help ourselves and others change our behavior, then it is clearly one of the most vital, yet scarcest, commodities on the planet. ...

The key to successful influence lies in taking these three powerful steps:
1. Identify a handful of high-leverage behaviors that lead to rapid and profound change.
2. Use personal and vicarious experience to change thoughts and actions.
3. Marshall multiple sources of influence to make change inevitable.

Identify ‘Vital’ Behaviors.The first step to any successful influence strategy is to decide what you’re trying to change. There are three big ideas here:

Focus on behaviors. Don’t even begin to develop your influence strategy until you’ve carefully identified the behaviors that need to change. ...

A few improved behaviors can drive a lot of change. Successful change agents ...understand that profound change requires a precise focus, so they home in on three or four vital behaviors.

Validate these behaviors by setting short-term goals within a low-risk environment. ... Create a small pilot study in which you can watch the effect of new behaviors on results. ...

Use personal and vicarious experience to change thoughts and actions. ...People base their actions on two critical questions: “Can I do it?” and “Will it be worth it?” Unless the answers are affirmative, you won’t change much behavior. The ... evidence is clear that verbal persuasion doesn’t work, at least not with profound, persistent and resistant problems.

Personal experience is the gold standard for changing beliefs. ... Launch a pilot test, take people on a field trip, or otherwise immerse users in a safe version of the experience. ...

When personal experience isn’t possible, use vicarious experience.

Marshall multiple sources of influence to make change inevitable. When you’re trying to influence persistent and resistant behaviors, don’t ask, “What’s the least I can do to influence change?” Instead ask, “What is the most I can do to make absolutely sure people will change?”

...The key to this diagnosis is not looking for the one crucial barrier, even though there may be one that stands out. The key is to address every single barrier to guarantee success.

Using these influence tools, you can solve any problem that can be affected through improved behavior — your own behavior or the behavior of others — from the simplest irritations to the most persistent, resistant and profound problems you can imagine.

1to1 Magazine, September, 2007

Marketers’ traditional approach to loyalty is training customers to tune out.

In this era of always-on marketing, customers are showing signs of fatigue. The multitasking digital lifestyle, constant media distraction in the home and workplace, and the hypercompetitive marketer's pursuit for customers' time and attention have driven valuable customers to tune out. Terms like cognitive overload, email attention deficit disorder, and data smog have filled the press lately. Marketing effectiveness is diminishing as a result. But that's not the worst of it. This tempest is shaking loyalty from its foundations. As a customer strategy, loyalty programs run the risk of losing effectiveness because companies can't get their messages through the marketing storm. When they do, customers often don't pay attention to them. Consequently, the approach to customer loyalty has to change. Here's how.

The Psychology of Next
"The human brain is an 'anticipation machine,' and 'making future,' is the most important thing it does…. Wonderful things are especially wonderful the first time they happen, but their wonderfulness wanes with repetition."

That quote is from Harvard professor Daniel Gilbert's award-winning book Stumbling on Happiness. ... The "anticipation machine" that runs our brain has become overfueled by the deluge of marketing messages, a proliferation of product choices, and ever-expanding channels to buy them from. Our society has become efficient at pushing "the psychology of next" and even better at downgrading the "next big thing."

If consumers are continually focused on "next," marketers may in turn suffer from a dearth of attention to their communications on "now," which could lead to a lack of customer knowledge and therefore a loosening grip on what makes customers happy.

Also contributing to customers' distraction is the culture of multitasking, which discourages attention. ..."Attention," says Umair Haque, a strategy consultant with Bubblegeneration, "is becoming the scarcest—and so most strategically vital—resource in the value chain. Attention scarcity is fundamentally reshaping the economics of most industries."

I Think, Therefore I Buy
Some marketers are getting desperate about capturing customers' attention at such NextGen touchpoints as email, online banners, and mobile messaging—key entry and tracking points for many loyalty programs. A June Wall Street Journal report addressed "banner blindness," showing how major agencies are trying to dress up the Internet's most basic advertising building block with video, new sizes, and new placements, all in the interest of trying to get and keep customers' attention.

The issue has reached the point where 54 percent of all consumer packaged goods companies recently surveyed by McKinsey had "significantly increased" their non-traditional marketing spending, including hiring "cool hunters" and using word-of-mouth marketing tactics. According to a July report in Harvard Business Review, 70 percent of all CPG marketing managers cited declining loyalty as their primary concern.

... DoubleClick's June research study on online loyalty showed that 71 percent of the customers surveyed browse multiple stores before they make a purchase and 42 percent consult a shopping comparison site or review site. Although 70 percent said they belong to at least one loyalty program, participation in it wasn't a big driver of purchase behavior. Price and free shipping were the most powerful factors in getting customers to return to an e-commerce site. ...

"Loyalty is a looser proposition than it used to be," says Stuart Frankel, president of the Performics division of DoubleClick, which conducted the survey. "Customers have more choices and when they're constantly being messaged about these things, and their appetite is constantly whetted for new things, you have to do more."

...Conceptually, loyalty is less, well, loyal than many companies and analysts once thought. For example, one study by U.K.–based Focalyst finds that Baby Boomers are loyal only to financial services and healthcare firms. Those "most likely to return" to brands in that demographic were high for insurance (72 percent), but low for frequently purchased items like apparel (26 percent).

A new report from mobile solutions provider SmartReply says turning up the marketing volume may not work. It claims that 60 percent of all consumers avoid advertising whether by using DVRs or ignoring Internet ads and 54 percent avoid products from companies that "overwhelm" them with marketing messages.

...What the Pew Internet project calls Generation Next (ages 18–26) doesn't seem to be loyal even to some of the Web sites whose success it has been most responsible for. More than 40 percent of customers who have a profile on MySpace have profiles on Friendster, Facebook, and other sites.

According to Terry Dry, cofounder of teen-focused online promotional firm Fanscape, loyalty is an allegiance to the next big thing and the next cool brand. "Kids don't feel like they owe you anything," he says. "They want what they want and they want something for their loyalty even if it's temporary. Keep delivering value and you have a shot."

New Loyalty Touchpoints
While there is every reason for companies to be concerned about the long-term consequences of marketing overload, there is also every reason to believe that loyalty programs can still be effective. ...The June 2007 study "Getting It Right at Retail," in the "Relationship Builder" series from Carlson Marketing, shows the impact of relationship strength.

Relationship strength is driven by emotional elements such as "trust" as well as economic advantages. The study found that when relationship strength is high, the customer is 49 percent more likely to remain a customer. In addition, a customer in a strong relationship is 1.82 times as likely to recommend the retailer to friends and family. ... As author Gilbert said, "Wonderfulness wanes with repetition."

Psychologists call that habituation. One way to beat habituation is to increase the variety of the experience. ... The loyalty of next has two main elements. One is the concept of emotional touchpoints. The second is the dynamically served loyalty program. ... "As people get used to getting what they want, when they want it, loyalty programs need to offer more than a toaster for the right customer behavior," says Mark Sage, director of loyalty for Carlson Marketing's EMEA division. "A company has to move as close as possible to on-demand loyalty rewards. If not, the amount of available choices that has made loyalty so loose a concept could tempt any customer."

...Sage believes loyalty programs can expand into a dynamically served customer portal that reflects purchases, interests, and lifestyles. ... The new entity would be a combination of a social network, e-commerce portal, and loyalty program. ...

The Softer Side of Loyalty
The new series of touchpoints Kaplan refers to have emotional and economic components. A new research report from New York–based branding agency Fletcher Knight, for example, shows that beauty brands based on an emotional connection have increased purchase intent and higher purchase frequency. ...

...According to Satmetrix CEO Laura Brooks, Ph.D., community can be an effective loyalty program. "Don't try to confuse buying someone's loyalty with growing it organically," she says. "A community can create what I call a referral spiral. It can change dynamically and become a good differentiator. And it makes people feel emotionally involved with the product or the company. Brand advocacy creates loyalty."

Dan Hill, author of Emotionomics, says loyalty to some extent will come down to "owning" abstract concepts. Disney, for example, aims to own "family fun." McDonald's aims to own "happiness." GM aims to own "patriotism." ...

Jungian Loyalty
Maybe the psychologist who had the best handle on the possibility and peril of customer loyalty was Carl Jung. Toward the end of his career he wrote: "A man can find satisfaction and fulfillment only in what he does not possess."

... People want what they can't or don't have and companies try to convince them that they need what they don't need and that they can have what they never thought they could own. Once customers are sold on this, companies then want customers to have more of what they make and to buy it more often.

"In the short term we've done a great job of creating anxiety," says Forrester analyst Lisa Bradner. "Lasting loyalty is emotive, social, dynamic, and creates a win-win for companies and customers. The long-term challenge is in forming stronger ties and being more authentic. Brands will need to address...customer needs if they want to be successful long term."

Companies can achieve customer loyalty regardless of the marketing environment and psychosocial mind-set. Some of the basics are still the most important, such as addressing customer value and designing brilliant customer experiences. But the customer loyalty program and customer loyalty concept is changing. It needs to blend the economic and the emotional. It needs to accept the conditions created by the ever-changing Internet landscape.

"I think this can all fit together brilliantly," says Colin Shearer, SPSS vice president, analytics. "Loyalty programs can still get the customer the next great thing or give them enough information to figure out what the next great thing is. I think we're developing a customer profile of 'next.' Now we need to treat them accordingly."

Money Magazine:  Aug. 23, 2007

Humankind evolved to seek rewards and avoid risks but not to invest wisely.

By Jason Zweig, Money Magazine senior writer/columnist

August 23 2007: 1:38 PM EDT

(Money Magazine) -- For most purposes in daily life, your brain is a superbly functioning machine, steering you away from danger while guiding you toward basic rewards like food, shelter and love.

But that brilliant machine can lead you astray when it comes to investing.

Jason Zweig is the author of "Your Money and Your Brain", Simon & Schuster (2007).

...We're beginning to get answers. Scientists in the emerging field of "neuroeconomics" - a hybrid of neuroscience, economics and psychology - are making stunning discoveries about how the brain evaluates rewards, sizes up risks and calculates probabilities.

... You, like every other human, are wired to crave what looks rewarding and shun what seems risky.

To counteract these impulses, your brain has only a thin veneer of modern, analytical circuits that are often no match for the power of the ancient parts of your mind. And when you win, lose or risk money, you stir up some profound emotions, including hope, surprise, regret and the two we'll examine here: greed and fear.

Understanding how those feelings - as a matter of biology - affect your decision-making will enable you to see as never before what makes you tick, and how you can improve, as an investor.

Greed: The thrill of the chase

Why is it so hard for most of us to learn that the old saying "Money doesn't buy happiness" is true? After all, we feel as if it should.

The answer lies in a cruel irony that has enormous implications for financial behavior: Our brains come equipped with a biological mechanism that is more aroused when we anticipate a profit than when we get one.

I lived through the rush of greed in an experiment run by Brian Knutson, a neuroscientist at Stanford University. Knutson put me into a functional magnetic resonance imaging (fMRI) scanner to trace my brain activity while I played a kind of investing video game that he had designed.

...When a shape signaling a small reward or penalty appeared, I clicked placidly and either won or lost. But if a circle marked with the symbols of a big, easy payout came up, I could feel a wave of expectation sweep through me. At that moment, the fMRI scan showed, the neurons in a reflexive, or emotional, part of my brain called the nucleus accumbens fired like wild.

When Knutson measured the activity tracked by the scan, he found that the possibility of winning $5 set off twice as strong a signal in my brain as the chance at gaining $1 did.

On the other hand, learning the outcome of my actions was no big deal. Whenever I captured the reward, Knutson's scanner found that the neurons in my nucleus accumbens fired much less intensely than they had when I was hoping to get it. ...

Why does the reflexive part of the brain make a bigger deal of what we might get than of what we do get? That function is part of what Brian Knutson's mentor, Jaak Panksepp of Bowling Green State University in Ohio, calls "the seeking system."

Over millions of years of evolution, it was the thrill of anticipation that put our senses in a state of high awareness, bracing us to capture uncertain rewards. ...

If we derived no pleasure from imagining riches down the road, we would grab only at those gains that loom immediately in front of us.

Thus our seeking system functions partly as a blessing and partly as a curse. We pay close attention to the possibility of coming rewards, but we also expect that the future will feel better than it does once it turns into the present.

A vivid example of this is the stock of Celera Genomics Group. In September 1999, Celera began sequencing the human genome. By identifying each of the 3 billion molecular pairings that make up human DNA, the company could make one of the biggest leaps in the history of biotechnology. Investors went wild with anticipation, driving the stock to a peak of $244 in early 2000.

Then, on June 26, Celera announced that it had completed cracking the code. How did the stock react? By tanking. It dropped 10.2% that day and another 12.7% the next day. Nothing had occurred to change the company's fortunes for the worse.

Quite the contrary: Celera had achieved a scientific miracle. So what happened? The likeliest explanation is simply that the anticipation of Celera's success was so intense that reality was a letdown.

Getting exactly what they wished for left investors with nothing to look forward to, so they got out and the stock crashed.

Greed: The stuff of memories

Researchers in Germany tested whether anticipating a financial gain can improve memory. A team of neurologists scanned people's brains with an fMRI machine while showing them pictures of objects like a hammer or a car.

Some images were paired with the chance to win half a euro, while others led to no reward. The participants soon learned which pictures were reliably associated with the prospect of making money, and the scan showed that their anticipation circuits fired furiously when those images appeared.

Immediately afterward, the researchers showed the participants a larger set of pictures, including some that had not been displayed inside the scanner. People were highly accurate at distinguishing the pictures they had seen during the experiment and equally adept at recognizing which of those pictures had predicted a gain.

Three weeks later the participants came back to the lab, where they were shown the pictures again. This time people could even more readily distinguish the pictures that had signaled a financial gain from those that had not - although they hadn't laid eyes on them in 21 days!

... It turned out that the potentially rewarding pictures had set off more intense activation not only in the anticipation circuits but also in the hippocampus, a part of the brain where long-term memories live.

... "The anticipation of reward," says neurologist Emrah Düzel, "is more important for memory formation than is the receipt of reward."

Anticipation has another unusual neural wrinkle. Brian Knutson has found that while your reflexive brain is highly responsive to variations in the amount of reward at stake, it is much less sensitive to changes in the probability of receiving a reward.

If a lottery jackpot was $100 million and the posted odds of winning fell from one in 10 million to one in 100 million, would you be 10 times less likely to buy a ticket? ...[Y]ou probably would shrug, say "A long shot's a long shot" and be just as happy buying a ticket as before.

That's because, as economist George Loewenstein of Carnegie Mellon University explains, the "mental image" of $100 million sets off a burst of anticipation in the reflexive regions of your brain. Only later will the analytical, or reflective, areas calculate that you're less likely to win than Ozzy Osbourne is to be elected Pope.

When possibility is in the room, probability goes out the window. ... That means your brain will tend to get you into trouble whenever you're confronted with an opportunity to buy an investment with a hot - but probably unsustainable - return.

Fear: What are you afraid of?

Here are two questions that might, at first, seem silly.

1 Which is riskier: a nuclear reactor or sunlight?

2 Which animal is responsible for the greatest number of human deaths in the U.S.? a) Alligator b) Deer c) Snake d) Bear e) Shark

Now let's look at the answers. The worst nuclear accident in history occurred when the reactor at Chernobyl, Ukraine melted down in 1986. Early estimates were that tens of thousands of people might be killed by radiation poisoning. By 2006, however, fewer than 100 had died. Meanwhile, nearly 8,000 Americans are killed every year by skin cancer, commonly caused by overexposure to the sun.

In the typical year, deer are responsible for roughly 130 human fatalities - seven times more than alligators, bears, sharks and snakes combined. Deer, of course, don't attack. Instead, they step in front of cars, causing deadly collisions.

...What it does mean is that we are often most afraid of the least likely dangers and frequently not worried enough about the risks that have the greatest chances of coming home to roost.

...According to a recent survey of 1,000 investors, there's a 51% chance that "in any given year, the U.S. stock market might drop by one-third."

In fact, the odds that U.S. stocks will lose a third of their value in a given year are around 2%. The real risk isn't that the market will melt down but that inflation will erode your savings. Yet only 31% of the people surveyed were worried that they might run out of money during their first 10 years of retirement.

If we were logical we would judge the odds of a risk by asking how often something bad has actually happened under similar circumstances. Instead, explains psychologist Daniel Kahneman, "we tend to judge the probability of an event by the ease with which we can call it to mind."

The more recently it occurred or the more vivid our memory of something like it in the past, the more "available" an event will be in our minds - and the more probable its recurrence will seem.

Fear: The hot button of the brain

Deep in the center of your brain lies a small, almond-shaped knob of tissue called the amygdala (ah-mig-dah-lah). When you confront a potential risk, this part of your reflexive brain acts as an alarm system - shooting signals up to the reflective brain like warning flares. (There are two amygdalas, one on each side of your brain.)

The result is that a moment of panic can wreak havoc on your investing strategy. Because the amygdala is so attuned to big changes, a sudden drop in the market tends to be more upsetting than a longer, slower decline, even if it's greater in total.

On Oct. 19, 1987, the U.S. stock market plunged 23% - a deeper one-day drop than the crash of '29. Big, sudden and inexplicable, the '87 crash was exactly the kind of event that sparks the amygdala.

...One bad Monday disrupted the behavior of millions of people for years. There was something more at work here than merely investors' individual fears. Anyone who has ever been a teenager knows that peer pressure can make you do things as part of a group that you might never do on your own.

But do you make a conscious choice to conform or does the herd exert an automatic, almost magnetic, force?

People were recently asked to judge whether three-dimensional objects were the same or different. Sometimes the folks being tested made these choices in isolation. Other times they first saw the responses of four "peers" (who were, in fact, colluding with the researcher).

...Brain scans showed that when the subjects followed the peer group, activation in parts of their frontal cortex decreased, as if social pressure was somehow overpowering the reflective, or analytical, brain. When people did buck the consensus, brain scans found intense firing in the amygdala.

Neuroscientist Gregory Berns, who led the study, calls this flare-up a sign of "the emotional load associated with standing up for one's belief." Social isolation activates some of the same areas in the brain that are triggered by physical pain.

In short, you go along with the herd not because you want to but because it hurts not to. Being part of a large group of investors can make you feel safer when everything is going great. But once risk rears its ugly head, there's no safety in numbers.

Fear: Fright makes right

I learned how my own amygdala reacts to risk when I participated in an experiment at the University of Iowa. First I was wired up with electrodes and other monitoring devices to track my breathing, heartbeat, perspiration and muscle activity.

Then I played a computer game designed by neurologists Antoine Bechara and Antonio Damasio. Starting with $2,000 in play money, I clicked a mouse to select a card from one of four decks displayed on the monitor in front of me. Each "draw" of a card made me either "richer" or "poorer."

I soon learned that the two left decks were more likely to produce big gains but even bigger losses, while the two right decks blended more frequent but smaller gains with a lower chance of big losses. ...

Early on, when I drew a card that lost me $1,140, my pulse rate shot from 75 to 145. After a few more bad losses from the risky decks, my body would start reacting even before I selected a card from one of them.

Merely moving the cursor over the risky decks was enough to make my physiological functions go haywire. My decisions, it turns out, had been driven by fear even though the "thinking" part of my mind had no idea I was afraid. Ironically - and thankfully - this highly emotional part of our brain can actually help us act more rationally.

When Bechara and Damasio run their card-picking game with people whose amygdalas have been injured, the subjects never learn to avoid choosing from the riskier decks.

If told that they have just lost money, their body doesn't react; they can no longer feel a financial loss. Without the saving grace of fear, the analytical parts of the brain will keep trying to beat the odds, with disastrous results. "The process of deciding advantageously," concludes Damasio, "is not just logical but also emotional." 

Daniel Kahneman: Master of the imperfect mind
8 tips for taming your brain
Quiz: Is your brain wired for wealth? 5 questions

Risk & Insurance Online - Story October 4, 2007

It is an odd fact of life that you often find what you are looking for in the place you would not expect to find it. For example, the best risk management books--such as Moneyball, Bringing Down the House and Fooled by Randomness--were not explicitly about risk management. Similarly, I find some of the best ideas concerning risk management come from science magazines.
By Beaumont Vance

In the June issue of Scientific American, regular columnist Michael Shermer frames the issue of decision-making from an evolutionary perspective. Decision-making, he suggests, is the product of the evolutionary drive towards efficiency:

"Life, like the economy, is about the allocation of limited resources that have alternative uses. ... It all boils down to energy efficiency. To a predator, prey are batteries of energy."

He then quotes Read Montague: "This doctrine mandates that evolution discover efficient computational systems that know how to capture, process, store and reuse energy efficiently."

The real problem with the state of our decision-making is that the environment for which these programs were designed no longer exists. There might be some nasty people at work, but it is unlikely that they are going to attack your village in the night.

In that confusion we can be tricked. Coca-Cola, Shermer points out, was shown in experiments to trick the human brain: "The Coke brand has a 'flavor' in the ventromedial prefrontal cortex, a region essential for decision-making."

A soft drink ad can impact the decision-making region of our brains.

Shermer's article is yet another arrow pointing at how our brains are not as well equipped to make decisions as we think. ...[B]ehavioral scientists have so far identified about 200 biases that cause us to make illogical decisions. If we are not aware of these, they will trip us up (see the July 2007 issue of Risk Management Reports on correcting biases.) But if we understand them, we gain an advantage when dealing with decisions involving risk....

Aside from allowing one to escape from unwanted cocktail party conversations, this little part of the brain is also very important for decision-making. According to Time (the January 29, 2007, issue, P. 116), this has been demonstrated in an oft repeated experiment in which researchers pose hypothetical situations to the subjects and measure how long it takes them to make a decision.

Josh Green of Princeton has made a career out of strapping people into an fMRI machine (or functional Magnetic Resonance Imaging machine), which can graphically depict brain activity, and asking them to make decisions involving the death of others.

For example, he proposes a situation in which a runaway train is headed for a group of five people. The train can be diverted to a side track, but there is one person standing on the side track. Therefore, by diverting the train and saving the five people, the guy on the sidetrack will be killed. In other words, it is a choice of letting five people die, or killing one person.

The researchers then measure how long it takes the subjects to decide. Readers should remember that in such a situation, lengthy deliberation will mean that five people will die; no decision is indeed a decision.

Then, to spice up what would be an otherwise tedious experiment, the researchers change the scenario. This time, the train is still heading for the five people standing on the track. But instead of pulling a switch to divert the train, the subjects are told that they can stop the train only by pushing a bystander in front of the train, thus derailing it and saving the five people. It is the same problem: Let five people die or kill one person.

In the first scenario, where the switch can be pulled, 90 percent of the subjects have no trouble deciding to pull the switch. However, in the second scenario, when they have to push an innocent bystander in front of the train, 90 percent choose to let the five innocent people on the track get killed.

According to Josh Green, the subjects use completely different parts of their brain on each of these decisions. In the former, logic tends to win out. In the latter, an older part of the brain takes control. It is the same decision, but our brain takes over and throws logic out the window when the circumstances change a bit.

This same experiment was conducted with people who have damage to the ventromedial prefrontal cortex (VMPC). It turns out that people with damage to the VMPC are three times more likely to advocate throwing a person to certain death to save five lives. They made the decision much more quickly than people with undamaged brains.

Human decision-making is a complex process that we still fail to grasp completely. While it is hard to see any practical applications to this study--aside from screening all decision-makers, board members and political leaders for VMPC damage--it is a great demonstration of the folly of believing that decisions can be entirely rational. ...

There are, however, some practical implications to these studies. ...[T]hey also demonstrate how differently people make decisions if they have to get blood on their own hands.

Think of this in the context of layoffs. A senior executive might make a rational decision to fire 500 workers. All managers in the company could agree that it is necessary for the survival of the company. After all, if the cuts are not made, the entire company could fold and then everyone would lose their jobs.

However, when the individual, lower level managers are asked to actually fire some of their own people, they balk. In other words, senior management is simply pulling the railway switch, while the line managers are pushing innocents under the train. No wonder layoffs are so difficult to execute!

We should be careful about our assumptions of what constitutes "rational" thinking. If ads for Coke can affect the VMPC, one has to wonder what else can rewire our decision machinery. The better we understand how our brain works, the better we can become at correcting deficiencies. Who knows, perhaps advertising Coca-Cola in the office place could nullify the problems caused by that pesky VMPC. Have a Coke and a RIF!*

(* For those of you not familiar with American corporate slang, RIF is the acronym for Reduction In Force. It is a euphemism for a layoff.)

BEAUMONT VANCE manages risk for Sun Microsystems Inc. This column was a complimentary excerpt from one of his latest "Risk Management Reports" newsletters, which he edits and publishes. For more information on how to subscribe to the full version of the newsletter, please visit www.riskreports.com/ .

Click here to read Beaumont's latest Risk & Insurance® columns.

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strategy+business Autumn 2007 

by Lord Andrew Turnbull

Across the developed world, the demographic profile is changing. According to United Nations projections, the proportion of the global population over 65 years old will triple between now and 2100, from 7 percent to 21 percent. The population is aging more rapidly in some countries, such as Italy and Japan, and less rapidly in others, such as the United States and the United Kingdom. But in all countries, this demographic shift raises challenging new questions, not just for retirement and how it is to be financed, but also for the world of work — and the transition between the two.

Although most people understand that this change is taking place, they do not realize how large it will be and what its implications are for our working lives, for how we provide in advance for retirement, and for how support and care will be provided and funded in the future.

Regrettably, we are also prisoners of a number of assumptions that, if they were ever correct, will no longer hold in a changed world.

Assumption 1: We’ll work long enough to pay for our retirement. Not necessarily. There has been a dramatic change in the ratio of years spent at work to those spent in retirement. We will have moved by 2050 from five years of work for each year of retirement to 1.7 years of work per year of retirement.

Assumption 2: As our society gets richer, we can afford to retire earlier. The basic flaw in this is that people are not taking into account increasing longevity and its associated higher costs. We may be wealthier, but retirement is more expensive.  For example, for people in the last 10 to 15 years of life, not only do health-care costs rise significantly, but new expenses are incurred for services they can no longer perform themselves, such as home repairs or landscaping.

Assumption 3: It is useful to retire people early, because there are not enough jobs for everyone. The belief that older workers must be displaced to free up jobs for younger ones was bad economics in the 1980s, and it is even more misguided now. Increased output generates more income and expenditure, and thus creates more jobs. The consequences of this “lump of labor” fallacy are serious: It fosters an ageist agenda in the workplace. Laying off workers over age 50 or forcing them to retire results in a loss of skills and intellectual capital. It also accelerates the drain on public and private pension funds.

Assumption 4: Income and status at work rise linearly, and people retire at their most senior position. In some countries, employment regulations make it difficult to con­tinue working once you reach the age of retirement or have officially retired from the organization. Perpetuating this approach reduces organizational flexibility and promotes ageism.

Assumption 5: We accumulate assets while working and spend them during retirement. People tend to invest in equities when younger, then shift toward annuities and other fixed-income instruments as they age. Yet we cannot afford to stop growing our income base too soon. Some of the money we are not drawing on in the early years of retirement still needs to be invested in growth-oriented funds or stocks, particularly if the size of our pension pot at retirement is not adequate.

Assumption 6: During retirement we won’t change residences more than once. The home we live in when we retire may be great for fit, car-driving 60-year-olds, but could become unsuitable later. Consequently, many older people continue to live in houses that are too big, are too expensive to maintain, and may pose hazards to them.

Assumption 7: The state will provide social and health-care services for us in our later years, allowing our children to inherit a significant portion of our estate. The shift in demographic ratios will make public social and health-care services extremely expensive. By 2050, the U.S. will have 2.6 people of working age for each person over 65. As a result, governments will be forced to reduce their commitments by insisting on the use of personal assets to pay for care before help from taxpayers is invoked.

As we have seen, many of the individual and collective assumptions about work and retirement are no longer valid. We must recognize that long lives are no longer unusual and plan for such a future.

For the individual, that means saving more and not fully counting on state care, corporate pensions, or inheriting a parent’s estate in its entirety. We also must be prepared to work longer, to keep learning, and to be flexible.

For this to occur, however, organizations must change as well. Leadership models need to be reconfigured so that management responsibilities can be transferred to younger staff. New advisory or client-facing roles could be created for senior managers so firms can continue to benefit from older employees’ experience and judgment after those individuals have handed over the reins.

Addressing the issue of our aging population is a matter for society as a whole. We need to remove restrictions on how pensions are drawn and provide retirement-financing products better suited to the longer lives of the elderly.

Changes are already afoot. Retirement and pension ages in many Organisation for Economic Co-operation and Development (OECD) countries are starting to increase. Restricting compulsory retirement will foster — or force — changes in work culture and minimize ageism.

But the bigger question re­mains: Are we prepared to live with the new assumptions that this demographic shift will require of us?

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