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Sadder But Wiser

The most famous poem written by British poet and philosopher Samuel Taylor Coleridge (1772-1834) is The Rime of the Ancient Mariner, about a sailor returned from a long journey to the South Pole who recounts his story to a passerby.  In this lengthy poem, Coleridge employs special literary techniques, including personification and repetition in a way that at times invokes a feeling of impending danger, the supernatural, or deep tranquility, depending on the prevailing mood of the different sections of the poem.  The mood of the ship’s crewmen also changes with the events that take place, from anger to joy, according to the fickle, volatile sea.  But even more than the literary techniques employed, this poem occupies a unique place in English poetry thanks to the many expressions that Colerigde coined that have since entered the language, the most notable of which is “sadder but wiser.”

Whether it is sadness that leads to wisdom or it is the wise who understand something that saddens them, the expression takes on special significance for anyone wishing to trace the link between our mood and the wisdom of the way we invest our money.

A study published recently in Australia supports what researchers have already known for more than two decades: that depressed investors perform better.  Joseph Forgas of the University of New South Wales conducted a series of studies in which he took pains to induce different moods in the participants and then checked their performance in a series of tasks.  The ill-tempered participants were more attentive to detail, less gullible, less likely to make errors of judgment and, when requested to do so, were able to put together more convincing arguments than their colleagues who were in better spirits.

The study, recently published in Australasian Science, also opens a window to interesting research methods that researchers in the behavioral sciences sometimes adopt when participants in an experiment are not in the appropriate mood.  In order to ensure the necessary level of melancholy or elation, the researchers used the Velten Mood Induction procedure, which is based on the reading of fifty-eight sentences beginning with the neutral (“Today is neither better nor worse than any other day”) and ending with sentences that are more and more positive (when the aim is to invoke a good mood) or more and more negative, when the opposite effect is desired.  Sentence #27 on the negative list is “I've doubted that I'm a worthwhile person” and the last sentence on this list is “I want to go to sleep and never wake up.”  Sentence #28 on the positive list is “My memory is in rare form today” and the last sentence on this list is “God, I feel great!”

Those people who doubt the efficacy of these sentences in developing the appropriate moods should recall the way they feel after a film or play that proceeds gradually toward a comic or tragic ending.  Even though we are aware that this is a fictional story we become involved emotionally.  It is important to remember that participants in the experiment were called on to perform a task a very short time after taking part in this procedure, and their reactions to the sentences they read are still fresh in their minds.

So what, then, is there about depression that makes those who suffer from it better investors?  The answer is far from simple, and is linked first and foremost to what depression lacks: optimism and overconfidence, two of the most destructive biases among investors.  While similar, there is an important difference between them.  Whereas overconfidence can be curtailed, especially with experience, optimism cannot.  It is the fuel that fires up entrepreneurs to estimate the results of their activities with rose-colored glasses and at the same time causes them to fail to foresee the inherent dangers.  That notwithstanding, it is important to understand that without optimism the economy would grind to a halt and gardening, reading and the development of human relationships would become central to our lives.

On the other hand, overconfidence is a character trait that can cause us, for example,  to miscalculating our ability to make payments when they are due.  In effect, most of us are late in making at least one payment due to a variety of temporary difficulties and daily problems; as a result, we are obliged to pay particularly high interest rates to the credit companies, who understand this tendency only too well.  Overconfidence is what causes investors to identify trends before they have actually formed, and then they take action according to this faulty identification.  Furthermore, people who are more confident than what is justified tend to ignore the effect of randomness (“luck”) on events and to underrate the other players in the market.

The term “depressive realism” was coined by researchers back at the end of the 1980s as a way of describing the surprising phenomenon that claims that people with depression have a more accurate perception of reality, especially in terms of their own place in the world and their ability to influence events.  How true it is that the sadder you are, the wiser you are.

What Disclosure Hides

The annual exhibition at the Royal Academy of Arts in London has long been an arena for artistic rivalry among Britain’s finest painters, and the exhibition of 1832 was no exception.  Paintings executed by two of the United Kingdom’s most illustrious landscape artists – J.M.W. Turner and John Constable – were hung side by side that year in the main hall.  Constable had been working on his painting, Inauguration of the Waterloo Bridge, for a decade.  On the day before the opening of the exhibition – known as Varnishing Day, when painters were allowed into the galleries to put finishing touches to their works – Constable took great pains with a few final brushstrokes to his painting, which was already hanging on the wall.  Turner stood by observing and decided to touch up his own painting as well – a seascape called Helvoetsluys – the City of Utrecht, 64, Going to Sea – by adding a small red spot, which became a buoy floating in the water, that is so prominent against the backdrop of the blue-gray sky and sea that one cannot stop looking at it.  Constable’s wonderful painting was pushed aside in the face of Turner’s genius.

The two had had a long history of rivalry before this incident, culminating the year before when Constable had sat on the Academy’s committee that decided which paintings would hang where and had relegated Turner’s painting to a side room and hung his own work in the newly vacated central spot.  Impulsive Turner resolved to use his prodigious artistic talent to avenge the man who had worked against him.  But not all of us are Turner, and conflict of interest is a widespread phenomenon.  So, what can we do when faced with such a situation?

First of all, we ask that people with a conflict of interest identify themselves and disclose their conflict of interest to all so that we may consider our subsequent actions with the necessary precaution.  In the capital market we are accustomed to seeing the general disclosure statements of warning that alert the reader of economic research reports, for example, to possible conflicts of interest on the part of the analysts who penned them.  The writer assumes the reader will know to judge whether there is inherent bias, and how to deal with it.  But is full disclosure enough to keep us safe from the ravages of the phenomenon?

George Loewenstein of Carnegie Mellon University and his colleagues Don Moore and Daylian Cain created a game that is not much different from the one we play when we invest in the stock market.  In Loewenstein’s game, players were asked to estimate the value of coins in a glass jar.  Loewenstein even provided the players with paid advisors who also took part in the experiment.  While the estimators were allowed to glance at the jar for only ten seconds, the advisors were more knowledgeable; they were given information regarding the actual spread of true values of the coins in the various jars, and the estimators knew this.  The goal of the experiment was to test the effects of conflicts of interest on the behavior of the advisors, but no less so, the effects of conflicts of interest on the behavior of the estimators.

The advisors who were asked to provide the estimators with recommendations regarding the value of the coins in the glass jar received recompense according to the accuracy of the estimation made by those they advised: the closer the estimate was to the actual value, the more money for the advisor.  In other instances, however, the advisors were paid on the basis of the value of the estimate made by the estimators who had received their advice.  The higher the estimate, the more the advisor received.  In these cases the advisors were clearly exposed to a conflict of interest; while the estimators anticipated receiving an accurate, objective estimate, the advisors’ financial motive encouraged them to recommend a high estimate.  Some of the estimators did not know how the advisors’ wages were determined while others did, and this latter group could assess the potential inherent conflict of interest and try to account for it in their estimates.  The results of the experiment were absolutely clear but not always predictable.

In cases in which the advisors’ wages were linked to the accuracy of their estimates they estimated the value of the coins in the jar at sixteen dollars.  Their estimates rose to twenty dollars when their wages were determined according to the value of the estimate made by their client, the estimator.  And what were their estimates when acting under full disclosure, revealing the fact that their compensation was linked to the value of their estimates?  Well, their ‘estimates’ rose to twenty-four dollars!  Various studies have shown that advisors’ behavior is based on a phenomenon known as ‘moral self-licensing.’  People who proclaim public incorruptibility may well demonstrate improper behavior at a later stage by relieving themselves of the guilt that comes along with behaving unfairly.

And what about the estimators?  While they tried to account for the potential conflict of interest, they failed to do so to a sufficiently significant degree.  Their estimates were on average four dollars lower than those of the advisors, while the latter raised their estimates by eight dollars the moment that the potential conflict of interest was disclosed.   The bottom line of Loewenstein’s study is disturbing: when conflict of interest was disclosed the advisors earned more money and the clients (estimators) less.

The solution to conflict of interest does not lie in full disclosure.  On the contrary, full disclosure becomes a moral fig leaf that expands the freedom of the advisors to act according to their own interests.  The true solution to this situation lies in the ability to avoid any kind of conflict of interest at all, which removes the need for disclosing it.



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