by: Issues: July / August 2009. Tags: Innovation. Categories: Innovation.

It is painfully ironic to think that the trigger of the financial meltdown – outrageous behavior – might have jammed if the principles of behavioural finance had been widely known and adhered to. Such principles can make an organization psychologically smart, even mature, and equip it with an early-warning system to prevent such behaviour.

The root cause of the global financial crisis that began in 2008 is the psychological excess that was manifest in unsound managerial judgments and poor managerial decisions. That excess was unevenly distributed across financial institutions, rating agencies, government bodies, households, and investors.

Much of that excess was preventable. But prevent it we did not. We did not prevent lax lending in the housing market. We did not prevent inaccurate risk ratings by rating agencies. We did not prevent excessive leverage by both financial institutions and individual households. We did not prevent a severe dilution of regulatory oversight.

Going forward, we need to figure out how to deal with our self-destructive elements. We need to learn how to build organizations that are psychologically smart. We need to structure organizational cultures that foster sensible approaches to risk-taking.

In my book, Ending the Management Illusion (EMI), I propose a series of practical steps that organization can take to address psychological excess. These steps involve the use of behavioral finance, the application of psychology to financial decisions. I suggest that organizations can use behavioral finance to make themselves psychologically smart. The starting point for this process is to face up to a major management illusion. That illusion is the belief that organizations can ignore psychological obstacles to effective decision making, and yet succeed in the long-run without being lucky.

The premise of EMI is that the psychological obstacles to effective decision making are concentrated in four important organizational processes. The four processes are:

  1. the setting of standards and goals
  2. planning
  3. incentives
  4. information sharing

I argue that addressing psychological obstacles effectively requires the development of a coordinated, integrated approach. This means setting clear accounting-based goals. It means planning with a view to execution and the achievement of goals. It means putting in place a balanced mix of financial and non-financial incentives which reward members of the organization according to how well goals have been met. It means excelling in the sharing of information about whether the organization is on track in carrying out its plans, achieving its goals, and rewarding its members.

In theory, carrying out the tasks described in the previous paragraph sounds straightforward. In practice, it is not straightforward. Psychological obstacles line the corridors, seeking to prevent organizations from carrying out those tasks successfully. Psychologically smart organizations structure their cultures to deal with those obstacles on a continuing basis and in an explicit manner. It is a never ending battle requiring constant vigilance.

Our psychological vulnerabilities are hard wired, ever present, and will not disappear. In what follows, I will describe how psychological imperfections were manifest in the processes at Merrill Lynch, one of the five investment banks collectively known as Wall Street. Many of the same issues that affected Merrill also affected other financial firms, and I will provide some examples in this regard. However, the focus on a single firm serves to underscore the importance of having an integrated process approach. But first, I want to remind readers about some of the primary lessons we have learned about the psychology of risk.

Psychology of risk taking

When financial firms make investments, they take risks in the hope of earning favorable returns. The work of psychologists Daniel Kahneman and Amos Tversky has taught us a great deal about the psychology of risk-taking. Consider a psychological choice problem from one of their experiments (Tversky and Kahneman, 1986).

Imagine that you face the following pair of concurrent choice tasks. First, examine the decision tasks. Then, indicate your choices in the knowledge that you will later learn the outcome of your choices simultaneously.

Choice task 1: Choose between

  1. a sure $2,400
  2. 75% chance of $0
    25% chance of $10,000

Choice task 2: Choose between

  1. a sure $7,500 loss
  2. 75% chance of losing $10,000
    25% chance of losing $0

The most frequent response pattern for these choices is that most people choose the sure gain A over the risky alternative B, and most choose the risky alternative D over the sure loss C. This experiment has several implications.

  1. Gains and losses are the psychological carriers of value, not final asset position.

  2. When only gains are involved, most people are averse to risk.

  3. If only losses are involved and there is a chance to avoid a sure loss, most people are risk seeking, a phenomenon known as aversion to a sure loss.

  4. If you were to compare how A&D combine to how B&C combine, you would discover that B&C is the better combination. Effectively facing B&C is equivalent to facing A&D but receiving an extra $100 on top. Because most people do not work out the combination, the decision frame is opaque rather than transparent, and the lack of transparency induces them to make an inferior choice.

There are many other concepts involved in the psychology of risk. Examples include excessive optimism, overconfidence, extrapolation bias, confirmation bias, and groupthink. Excessive optimism leads people to look at the world through glasses that are rose-colored. Overconfidence leads people to be too sure of their opinions, a tendency which frequently results in their underestimating risks. Extrapolation bias leads people to forecast that recent changes will continue into the future. Confirmation bias leads people to overweight information which confirms their prior views, and to underweight information which disconfirms those views. Groupthink leads people in groups to act as if they value conformity over quality when making decisions.

Armed with the ideas in this short introduction to the psychology of risk, consider next how these various features combined to wreck havoc in the financial services sector.

Merrill Lynch: Ignoring the Management Illusion

Merrill Lynch had been among the best-known brokerage firms in the world, widely recognized for its use of a bull as its logo to denote bullishness. However, Merrill had become much more than a brokerage firm. It was also an investment bank, one of the five major houses that collectively came to be known as “Wall Street.” Despite all that, in September 2008, Merrill Lynch sold itself to Bank of America in order to avoid bankruptcy.

The prior twelve months had been a downhill slide. The previous October, Merrill announced the largest loss in its history, $2.3 billion, which reflected a $7.9 billion write-down from its exposure to securities known as collateralized debt obligations (CDOs). During the first nine months of 2008, the firm recorded net losses of $14.7 billion on its CDO positions. Through October 2008, approximately $260 billion of Merrill’s asset-backed CDOs had begun to default. For Merrill, this was a cost of having ineffective processes in place that failed to address psychological biases.

The epicenter of the global financial crisis is the housing market in the United States. From 1997 to 2006, U.S. home prices rose about 85 percent adjusted for inflation, making this the biggest national housing boom in U.S. history. The rate of increase was five times the historical rate of 1.4 percent a year. I think it is fair to call this a bubble. Because of the extrapolation bias, the sentiment of many people was that housing prices would continue to increase by about 10 percent a year.

Continue to increase they did not. The bubble burst. Housing prices peaked in 2006 and then began to decline dramatically. Between June 2007 and June 2008, housing prices declined by more than 15 percent. For many homeowners, the value of their mortgages exceeded the value of their homes. Some in this situation decided to default on their mortgages. Some homeowners had taken out adjustable rate mortgages with low initial rates that after a period of time would reset to rates that were much higher. These homeowners were planning on refinancing before the higher rates kicked in. However, once housing prices began to decline, homeowners found that they did not qualify for refinancing. Many were unable to afford the higher rates and had to default.

Merrill Lynch held many of these mortgages, and the mounting defaults reduced the value of those mortgages. A substantial portion of Merrill’s losses stemmed from the use of complex financial derivatives. Derivatives are just like other investments, and are not dangerous if used sensibly. However, many of the financial services firms who used derivatives did not use them sensibly. Instead they forgot about a few basic principles.

One principle is that if you loan somebody money and they don’t pay you back, you incur a loss. This principle still holds if you loan them money to buy a house. It holds in spades if the homeowner’s credit is shaky.

A second principle is to be aware of being the greater fool. The Greater Fool Theory is about trading overvalued assets in a bubble, that investors will buy overvalued assets because they believe that they can sell them to someone who is a greater fool than them.

Who were the greatest fools? The ones who leveraged their bets in order to make lots of money in good times but risked huge losses in bad times? The ones who insured the losses of other holders of subprime mortgages? Driven by psychological imperfections, the greatest fools did both.

In EMI, I described some of the process issues that led financial firms to fall into a series of behavioral traps. In what follows, I will take you through a quick tour of Merrill’s experiences, viewed through the prism of the four processes emphasized in EMI. I begin with planning.

1. Planning

The starting point for discussing Merrill Lynch’s planning process is a description of its customers, businesses, and competitors. Merrill’s customers are private clients, small businesses, and institutions and corporations. In November 2008, the firm described itself on its website as “a world leader in wealth management, capital markets and advisory companies with offices in 40 countries and territories and total client assets of approximately $1.5 trillion.” In terms of businesses, Merrill organized its activities into two interrelated segments, called respectively (1) Global Markets & Investment Banking and (2) Global Wealth Management. In November 2008, the firm’s workforce comprised about 70,000 employees.

As to competitors, Merrill Lynch was one of five large Wall Street investment banks. The other four were Goldman Sachs, Morgan Stanley, Lehman Brothers, and Bear Stearns. As the global financial crisis unfolded during the autumn of 2008, Goldman Sachs and Morgan Stanley became bank holding companies to weather the storm. To stave off bankruptcy, and with the help of government guarantees in respect to its losses, Bear Stearns agreed to be acquired by commercial bank J.P. Morgan. Lehman Brothers would have chosen to follow Bear Stearns’ route, but the government resisted providing guarantees. This turned out to be a very bad judgment call on the part of the government. As a result Lehman Brothers went bankrupt, and the ensuing fallout led to major declines on world financial markets.

The main source of Merrill’s planning mistakes stem from its financial situation before 2005. In July 2004, Merrill reported that its second-quarter net income rose 10 percent, noting that its revenue was nearly flat. Notably, net revenue in the global markets and investment banking segment fell 7.3 percent. In a prepared statement, CEO Stanley O’Neal stated: “We navigated through a progressively more challenging business environment during the second quarter.”1

Merrill’s performance was positive but well below those of its chief competitors, especially Lehman Brothers. Just a few months before, Lehman was reporting outstanding performance for its investment banking, capital markets and client services businesses, with record first-quarter income, net income rising by 39 percent from the prior year, and net revenue up by 84 percent, with Europe and Asia up by 57 percent. Clearly, Lehman’s business environment was not as challenging as that of Merrill.

In interviewing former Merrill executives, The New York Times learned that Merrill was especially envious of Lehman’s performance.2 In their planning process they contrasted their own weak investment-banking performance with the strong performance at Lehman. In particular, they focused on Lehman’s ability to profit from the market for mortgages and mortgage-based products.

2. Standards for Risk

Standards include targets and goals that relate to accounting controls, including limits. I would suggest that by virtue of being behind the competition, the appetite of Merrill’s executives increased to the point where they became risk neutral, if not risk seeking. Recall the psychological choice task discussed earlier. Two of the key findings from studying the psychology of risk are that: (1) people frame decision tasks in terms of gains and losses relative to a reference point; and (2) people have difficulty accepting a sure loss and often choose a risky alternative instead, even if that alternative features a lower expected payoff.

The comments made by former Merrill executives, as reported in The New York Times, suggest that the reference point for the company corresponded to the performance of its competitors. Having set a very high reference point, the firm then developed a high-risk strategy to transport itself into the domain of gains. That strategy was centered on emulating Lehman’s strategy of using mortgages. For Merrill, this meant originating mortgage loans, administering the associated paperwork, packaging mortgages into CDOs, and then selling the CDOs to investors.

CDOs are akin to mutual funds where the funds hold bonds instead of stocks, and the funds’ investors hold bonds with varying degrees of priority in the event of default. The risk classifications are called tranches, and investors pay lower prices for riskier tranches. Holders of the equity tranche absorb the first losses stemming from default. If, at some point, the holders of the equity tranche receive zero cash flows from the underlying assets, holders of the next tranche begin to absorb losses. Holders of the senior tranche are the most protected.

To put its strategy into place, Merrill made a series of acquisitions. In the two years between January 2005 and January 2007, the firm acquired a dozen residential or commercial mortgage-related companies or assets. It made purchases around the world for commercial properties, a loan servicing operation, and a mortgage lender. Its largest acquisition was the domestic subprime lender First Franklin, which meant that it would concentrate its strategy in the riskiest segment of the housing market where the probability of default by borrowers was highest.

There are two aspects associated with standards that are particularly germane to financial firms: goals and risk management. Merrill’s goals focused on revenues and earnings. However, its standards for risk management were much weaker. The evidence suggests that it did not put corresponding risk management standards in place that would limit the associated risk. The New York Times reports that at one point in 2005, Merrill was engaged in merger discussions with North Fork Bancorp. The merger did not take place. North Fork Bancorp executives were not simply uncomfortable with Merrill’s risk profile. They were especially uncomfortable with the sense that Merrill’s executives did not fully understand the risk profile of their own firm.

Part of the problem with risk management at Merrill was the opaqueness of the financial instruments. And here is a key lesson from the psychological choice task described above. Recall that in that task, most people’s decisions reflect the manner in which information is presented to them. Information can be presented transparently or opaquely.

Think back to the specific psychological choice problem described above. Remember that even though facing B&C is superior to facing A&D, most people choose A&D instead of B&C. If the information is described transparently so that most people clearly see that facing B&C is equivalent to facing A&D and receiving an extra $100 on top, virtually everyone will choose B&C over A&D. However, if the information is presented opaquely, then most people choose the inferior A&D over the superior B&C.

CDOs can be opaque. The assets inside a CDO might be mortgage-backed securities, pools of mortgages that vary in terms of their underlying risks. Pooling injects opaqueness. Slicing the cash flows into tranches makes the risk even more opaque. Merrill injected additional opaqueness into its mix by relying heavily on a type of CDO known as a synthetic CDO. A synthetic CDO uses credit default swaps rather than bonds as the underlying asset. This is effectively structuring the CDO on pools of policies that insure against bond defaults instead of structuring the CDO on the bonds themselves.

When it comes to poor risk assessment, there is lots of blame to be shared. Rating agencies such as Standard & Poor’s themselves suffered from psychological biases. Like Merrill, McGraw-Hill, the parent company of S&P, set a high reference points for S&P’s profits. In the drive for higher revenues, S&P agreed to rate complex products. In the drive for lower costs, S&P did not provide sufficient resources to its analysts. Between 2002 and 2006, S&P’s revenue from rating mortgage-heavy bond portfolios increased by more than 800 percent. Yet related staffing only doubled. Internal emails at S&P make clear that the analysts rating CDO risk were well aware of the opaqueness issue and uncomfortable with having to rate the associated risk. The combination of appetite for revenue and insufficient resources led S&P to assign mortgage-related products ratings that were much too high.

3. Information Sharing

Poor information sharing accentuated Merrill’s poor inadequate risk management practices. Indeed, Merrill’s senior management actively worked to downplay concerns about excessive risk. The key personnel in this regard were Ahmass Fakahany and Osman Semerci. Fakahany oversaw risk management at Merrill, and loosened internal controls. Semerci ran the firm’s bond unit and oversaw its mortgage operation.

Former Merrill executives describe Semerci as an intimidating person who silenced anyone who warned about the risks the firm was taking. In respect to information sharing, he is alleged to have chastised traders who communicated their concerns to risk management officials. The New York Times quotes an anonymous former Merrill executive who stated: “There was no dissent … so information never really traveled.” This was classic groupthink, by design.

Groupthink is a form of collective confirmation bias. A person who exhibits confirmation bias overweights information that confirms his or her views and underweights information that does not confirm those views. Here is an example of confirmation bias. In order to protect against risk, Merrill had effectively put insurance contracts in place with the insurance firm, American International Group (AIG). Notably, at the end of 2005, AIG became reluctant to continue providing this protection, explicitly stating that it had concerns about the mortgage market. This perspective did not confirm Merrill’s views about the mortgage market. Merrill pretty much continued on its prior path. In addition, it was unable to find a replacement for AIG to insure its risks. This too did not confirm its views about the mortgage market. As a result it continued to take on more risk, but did so without the kind of protection it formally received from AIG.

During 2007, homeowners began to default on their mortgages. This led the ratings on mortgage-based CDOs to fall, and the market for these products became illiquid. Those holding these products, including Merrill, found themselves unable to sell. As was mentioned previously, in October 2007 the firm announced that because of its CDO exposure it would write off $7.9 billion.

4. Incentives

In theory, compensation provides managers with incentives to maximize the value of their firms. Compensation frameworks often rely on a combination of a bonus plan that relates to the short-term and equity-based compensation that relates to the long-term.

Did Merrill pay CEO Stanley O’Neal for performance? It certainly paid him well when the firm did well. Moreover, its board did fire him when losses began to mount. However, O’Neal made out well overall. He received $70 million in compensation over the four years he was CEO, and his severance package was worth $161 million.

Academics routinely criticize CEO compensation for being insufficiently variable with performance. This might have been the case at Merrill Lynch. That being said, my sense is that simply structuring better compensation packages would not have prevented Merrill from taking the value-destroying decisions that it did. The value destroying decisions stemmed not from conflicts of interest so much as from psychological excesses associated with high reference points, excessive optimism, overconfidence, opaque framing, and confirmation bias.

Incentives failed to prevent Merrill Lynch from making bad judgments about mortgage-related risk, and to choose positions that exposed it to unwarranted risk. In this they were not alone, as many financial institutions behaved similarly. At the market level, the failure of incentives upstream in the mortgage process allowed unaffiliated mortgage brokers downstream to originate very risky subprime mortgages but not hold the risk themselves, instead passing it upstream to large financial institutions. This created a systemic incentive issue which affected many investors, of which the Ontario Teachers’ Pension Plan Board was one. The Pension Plan Board is one of several investors who filed a complaint against Washington Mutual (WaMu), which went into receivership in September 2008 and was taken over by JP Morgan.

Underwriters at WaMu, like analysts at S&P and traders at Merrill, came under pressure to downplay risk levels. Underwriters serve to oversee all the documentation associated with a mortgage application, ensuring that the documents are in order and that the loan applicant has the appropriate financial standing to merit the mortgage. Mortgage brokers, eager for commissions but able to pass along risks, pressured underwriters to give their stamp of approval to loan applicants who did not have the appropriate financial standing. However, it was not just the brokers who applied pressure to underwriters. When underwriters resisted, they were harassed by their superiors who issued warnings and followed up with letters into their employment files.

5. Summary

In Ending the Management Illusion, I describe how behaviorally sound companies structure their cultures to recognize and address psychological imperfections. I describe cases of companies that do this successfully. Notably, none are financial companies.

Events at Merrill Lynch vividly illustrate the need for a behaviorally intelligent organizational culture. Merrill is hardly alone. Citibank, the largest American universal bank, failed to understand the risks it was taking and only survived because it was judged too big to fail and therefore received a large bailout from the U.S. government.3 Its Swiss competitor, UBS, has received a large bailout from the Swiss government. UBS has acknowledged that it did not understand the risks it was taking. The executives at AIG who were responsible for insuring firms like Merrill Lynch at one point told investors that they would receive the equivalent of insurance premiums, but would never have to pay the equivalent of claims.4 In 2004, the five major Wall Street investment banks successfully petitioned the Securities and Exchange Commission (SEC) to raise leverage limits dramatically, from 12 to 40! Not all banks increased their leverage as high as 40, although one did – Merrill Lynch. The banks thought they were capable of handling the associated risks, but events showed all five to be seriously overconfident, along with the SEC.

Financial markets reflected psychologically induced errors, and were not self-correcting without major chaos taking place. As a result, it is virtually certain that, going forward, strong new financial regulations will be implemented. Even better would be for leaders of financial firms to recognize the importance of behavioral finance and figure out how to end the management illusion.


Dow Jones News Service, 2004. “Lehman Brothers Reports Record 1Q Earnings Of $670M,” March 16.

Dow Jones Business News, 2004. “Merrill Lynch’s Earnings Rose 10%; Revenue Nearly Flat,” July 13.

Morgenson, Gretchen, 2008. “The Reckoning: How the Thundering Herd Faltered and Fell,” The New York Times, November 9.

NPR: Fresh Air, 2008. “Merrill Lynch and the Mortgage Crisis,” November 13.

Norris, Floyd, 2008. “Another Crisis, Another Guarantee,” November 25.

Shefrin, Hersh, 2008. Ending the Management Illusion. New York: McGraw-Hill.

Tversky, Amos and Daniel Kahneman, 1986. “Rational Choice and the Framing of Decisions,” Journal of Business, 251-278.

  1. Quoted in Dow Jones Business News: see the references.
  2. All statements about Merrill Lynch that involve The New York Times pertain to an article written by Gretchen Morgenson; see the references.
  3. See The New York Times article by Floyd Norris.
  4. See The New York Times article by Floyd Norris.