Humans have a very strange ability to understand how irrational we are and yet build complex systems which demand that everyone involved is perfectly rational. In his appearance on the Daily Show, writer Justin Fox hit that nail on the head when talking about the current ideas underlying the modern stock market. Rather than try to predict how to deal with greed, excess or impulsive decisions, these ideas see every trader like a machine. Cold, calculating and rationally thinking through every obstacle to get maximum profit or minimum loss. But in the real world where the complexities of human behavior tend to intrude on narrow proposals, it doesn’t work that way. If it did, there would be no subprime bubble. Everyone would know when to stop issuing loans.
Here’s a good example of how powerful human emotions are in financial decisions. A recent study using an ultimatum game found that more than 70% of people will punitively reject a bad deal even if it means they get absolutely no gain from the exercise. Ordinarily, according to the idea that humans should be rational when it comes to money, any offer in the ultimatum game should be accepted. When two people are told to decide on how to split some amount of cash, they can either agree on a split and walk away with at least a few dollars or reject it and both of them walk away with nothing. Obviously, walking away with even a tiny sum leaves them a bit better off than when they started. But when the splits venture from the 50/50 and 60/40 rate, rejections soar because the slighted participants no longer care about the money. It’s about bringing the hammer down on a greedy opponent. Their goal is not to win money, it’s not to let the other person get any of it.
A scholar behind the current ideas of how markets should function would be appalled at this behavior. Why in the world would they care about punishment more than they’d care about money? Because, as the research team behind the study clearly notes, humans are social mammals. Our instinct to punish whose who wrong us even if it means we have to spend resources and effort to do it is an evolutionary asset. It helps us keep an otherwise unruly society orderly. It’s the mentality which created our justice systems, prisons and systems of capital punishment. To us, an 80/20 split in an ultimatum game isn’t a chance to make a buck. It’s an offense that must be dealt with in no uncertain terms. And it’s good for the market because terrible terms which give a certain party an unfair advantage alienate customers, limiting the offender’s opportunities and encouraging a competitor to offer better, more transparent terms. Well, until greed overshadows our ability to pay attention to what those terms actually are…
See: Yamagishi, T., et al. (2009). The private rejection of unfair offers and emotional commitment Proceedings of the National Academy of Sciences DOI: 10.1073/pnas.0900636106