The final programme in the documentary series The Love of Money finishes by ascribing the causes of many financial crises, including the most recent, to a “reckless love of money”. Over the series, we have seen how reliance by banks on imprudent investments in property loans with high default risk led to the near total collapse of the world’s financial systems.

Was this the consequence of the actions of a powerful few, driven by extraordinary levels of greed and recklessness, or can the roots of the crisis be found in much more commonplace aspects of human psychology? I am going to argue that there is a great deal in common between the psychology of every day decisions about money and the psychological processes involved in the creation of this global financial crisis.

Consider two examples:

Jenny has recently lost her job, she knows that money is tight and she needs to reduce her costs dramatically, but every time she tries to think about sorting things out she feels bad and ends up by going shopping to cheer herself up.

Jared took on a 100% loan to buy a house with repayment levels he could only just afford. As he thought about this decision from time to time, he felt anxious about the possibility that he would not be able to meet the payments. He was able to avoid this anxiety by focusing on the way in which house prices seemed to keep on rising and by telling himself it was really a ‘one way bet’.

In each case there is a common factor: employing a strategy to avoid bad feelings and maintain good feelings, rather than facing the real problem or risk. We all behave like this from time to time. We all have strategies to regulate our emotions and often do so with the goal of avoiding bad feelings. However, when we feel particularly anxious or are powerfully motivated by an important goal, this tendency can cause us to ignore the important information that negative feelings can carry. Often this can involve fostering illusions about ourselves and the world around us which help us feel better.

Stock market results in a newspaper.
[image © copyright Jupiterimages]

We might imagine that professional financial decision-makers would be better at avoiding such traps. After all they work in a climate which places a great premium on rational decisions. However, in a large-scale study of 118 traders in four City of London investment banks, myself and colleagues found traders to be just as prone to these kinds of illusions as the rest of us. In particular we studied traders’ propensity to suffer from the illusion of control: the tendency to believe we are more in control of events than we really are (especially under stress). We found a significant relationship between a tendency to suffer from illusions of control and poor trader performance (including poor management of risk).

How might this relate to the causes of financial crises? One example back in the early 1990s is worth recalling. Peter Baring has been reported as telling shareholders at an AGM one year before the collapse of Barings’ Bank that, on the basis of the previous year’s performance, he had concluded it is easy to make money in the derivatives market. A year later the bank was valued at £1.

Any banker understands that there is a strong relationship between risk and return. Faced with unusually good financial performance in part of a bank’s operations, an important question to ask is “What hidden risks are we carrying that account for this high return?” However, faced with good returns, it is tempting to foster the illusion that good performance is a result of our unique skills and capabilities, while failures are due to events beyond our control. This tendency is known by psychologists as the self-serving bias.

This unwillingness to seriously question what hidden risks lay behind unusually high returns seems to have been an important factor in the recent demise of Lehman brothers and other major banks. A reckless love of money seems to have fuelled collective illusions about the risks being faced.

We need to understand more about how these kinds of emotion regulation processes work in financial decision-making. Current research is helping us understand these processes and how such blindness to risk can be reduced. The European Commission has funded me and an international group of researchers to conduct a major study looking at ways of improving financial decision-making. This study is looking at traders, investors and private citizens, and is paying close attention to the role played by emotions in their decision making.

Take it further

• Trading on emotion
• Has Robert Peston caused a recession?
• Bankers won, politicians lost

Further reading

Traders: risks, decisions, and management in financial markets, by Mark Fenton-O'Creevy, Nigel Nicholson, Emma Soane and Paul Willman, was published by Oxford University Press.

About the author

Mark Fenton-O'Creevy is Professor of Organisational Behaviour at the OU Business School. His research includes investigations into the performance of traders in financial markets, and the problems that occur when management practices are transferred from one country to another.

He is also a National Teaching Fellow, and Principal of the Centre for Practice-Based Professional Learning.

Subscribe to Mark Fenton-O'Creevy's posts

 

The financial crisis and global recession have made many commentators ask, "Are the prevailing business models bust?" Twenty years after the fall of Communism in Europe, has the last nail been put in the coffin of the market as the organising principle of civil society?

In a recent edition of The Bottom Line, executives of three companies reflected on how to plan for the long term in the face of the recession and the possible upturn. Simultaneously, a number of influential bodies, including the Engineering Employers Federation (EEF), are calling for the establishment of a national investment bank. Is planning back in fashion and will we see Indicative Planning regain favour? Furthermore, are there lessons to be learned from GOSPLAN, the Soviet Union’s economic planning committee?

Is planning back in fashion?

The recent dominance of financialisation, with its accompanying short-termism and reification of shareholder value, is deemed to be fundamental to our present difficulties. Not all sectors of the economy can plan for the longer term. Mining; oil and gas exploration and refining; engineering and industrial and commercial construction; project management and so on are subject to indivisibilities and long lead times, so planning in a technical sense is a must. The challenge is whether planning can be scaled up to the aggregate level of the economy in order to provide the critical mass on which business models can be built and sustained.

Herbert Hoover during his time at the US Department Of Commerce.
[image in the public domain, owned by US Department of  Commerce, accessed from  Wikimedia Commons]

Indicative planning involves co-ordinating the private and public sector’s investment and output plans, on the basis of forecasts and targets. It is most strongly associated with the development of the French economy in the post-War era, but its lineage can be traced back to the influence of Herbert Hoover in 1920, when he was US Secretary of Commerce. Today, one can see versions of indicative planning (in the form of sectoral targets) in the emerging economies, influenced perhaps by the organisational underpinnings of a number of advanced Asian economies.

In some senses, these later versions of indicative planning are voluntary versions of GOSPLAN, whose targets and plans were implemented using input-output analysis. Input-output models were invented by the Nobel Prize winning economist Wassily Leontief. They link the outputs of different industries in the economic system to show how change in one part affects all other parts. Perhaps, if the leading economies of the world had embraced indicative planning using similar analysis and decision-matrix techniques, some of the worst aspects of the economic and financial crisis may have been avoided.

This matrix approach is at the heart of Scenario Planning, which was developed by Herman Kahn to model the likelihood of thermonuclear war. It can also be seen as part of Indicative Planning and related to input-output analysis. It was versioned for large industries and organisations to undertake long-term flexible planning, based on a range of plausible scenarios.

...hoping for a return to normal based on "business as usual" appears to be very short-sighted, even for sectors whose market horizons are quarterly or seasonal.

It could be argued that the credit crunch and global recession are akin to a thermonuclear shock to the world economy. In this scenario, hoping for a return to normal based on "business as usual" appears to be very short-sighted, even for sectors whose market horizons are quarterly or seasonal. This response is about survival rather than sustainability. The cost of this survival is borne by the whole economy. There may be a revival of faith in induction (generalising from an individual perspective to make sense of the whole) but, in a complex system, one organism doesn’t account for everything.

John Maynard Keynes.
[image in the public domain, owned by the IMF, accessed from  Wikimedia Commons]

For the guests appearing on The Bottom Line, with their businesses in large-scale project management (trucks; and plumbing and piping), discussing the long-term did not engage with the epigram of the economist John Maynard Keynes from his masterly Tract on Monetary Reform of 1923: “In the long run we are all dead”. The full quote gives Keynes’s intention to show that the current state of affairs is no guide to the future

“The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again”.

The insights of great economists notwithstanding, if businesses don’t attempt to plan and we have an economic system that appears indifferent to the future, then we all will have shorter life spans.

Find out more

These Open University Business School courses will help make your planning sharper:

Engineering the future
Making sense of strategy
Capacities for managing development

Image of John Maynard Keynes [© Wikimedia Commons]

About the author

Leslie Budd is Reader in social enterprise at The Open University Business School. He is an economist and has written extensively on the relationship between regional and urban economics, and international financial markets.

Subscribe to Leslie Budd's posts

 

It’s easy to show that size impacts profitability but, in practice, managers frequently can only make decisions that affect size in the medium to long term. In the short term they are highly constrained by their existing set-up, always limited by demand in the market place.

A container lorry.
[image by 28481k, some rights reserved]

All businesses have two types of cost: fixed costs (that do not vary with output) and variable costs (that increase as output increases). To illustrate with a simple example, suppose you had a heavy goods driving licence and wanted to run a trucking service. You buy a truck for £100,000 and you can use it for five years. Before you drive a kilometre, you have a fixed cost of £20,000 a year to pay for the basic equipment. Items such as annual insurance and road tax raise the fixed costs to £25,000. Leaving aside your salary, every kilometre you drive costs (say) £1 in diesel, servicing, tyres and so on. So you have fixed costs of £25,000 and variable costs of £1 per kilometre. In the short term you have to work within those constraints.

The size of your business is critical. If you can sell transport at £6 per kilometre travelled, you need to sell at least 5,000 kilometres to break even:

Suppose the physical limitations are that you can drive a maximum of 75,000 kilometres a year. You can see that your profitability will vary according to the amount of work you do. Below 5,000 kilometres a year, you have no salary and are making a loss. Between 5,001 and 75,000 kilometres a year, every extra kilometre adds £5 to your earnings (£6 price less £1 variable cost) so your earnings rise uniformly to £350,000.

However, the moment you increase your activity beyond 75,000 kilometres, you have to acquire a second truck and hire a driver, so profits would then decrease as size increases. You’re either too big or not big enough at that level of activity.

There is also the issue of whether there is enough business available so that you can expand without limit. Often this is not the case and, as you look to boost business, you have to reduce prices. In an ideal world you would maintain your basic price of £6 for some business and offer special deals to gain extra business. As long as you were getting more than £1 and you were already covering fixed costs, you should increase earnings. However, it is difficult to reduce price in a limited way and you may find that existing business moves down from £6 to perhaps £4, so your increase in size reduces the value of your sales while increasing your variable costs – you’ve got too big.

The effects of size can be both beneficial and damaging.

Size matters at the individual business unit level but it also matters in the multi-unit business. The effects of size can be both beneficial and damaging. On the positive side, a multi-unit business can spread its risks better. A costly, failed business initiative can wipe out a single unit business instantly, whereas a multi-unit business can more easily bear the risk of expansion. Also, a multi-unit business can afford to have in-house specialists who bring extra expertise to aspects of management of the business.

On the negative side, key decisions are usually made remotely from the business unit. Normally the group operates with business budgets that must be agreed the year before and then adhered to. This can build in inflexibility because there is usually resistance to departing from the budget to take advantage of an opportunity that presents itself. Equally, central management will be concerned at managing risk across the group, and may turn down an expansion possibility in one unit because it prefers to take a risk in another. The group will probably establish standard procedures that sometimes do not make sense at unit level.

The bigger a group is, the more remote central decision-makers are from front line businesses and so the more controls the group needs in place to monitor what is happening at the unit level. These added layers add costs and not profits, they cause delays in seizing opportunities and often end up making front line staff feel frustrated and unappreciated. Big can be stifling.

Find out more

Get to grips with the big business questions: visit The Open University Business School

Watch Evan Davis discuss the right size for companies

About the author

Professor Peter Walton is a member of the Accounting & Finance Unit at the Open University Business School. His research interests are in comparative international accounting and financial reporting in an international context.

Subscribe to Peter Walton's posts