By Philip Coggan
Financial Times, 15 October 2004
There were no weapons of mass destruction in Iraq. And the security situation in Baghdad, while not a complete catastrophe, can hardly be described as going to plan.
To some people, these consequences are the direct result of "lies" by political leaders in the US and the UK. But it is equally possible to explain the actions of politicians in the light of the psychological traits popularised by the field of behavioural finance.
Behavioural studies have shown that individuals do not behave like the "rational man" beloved by economic models. They do not calmly assess all the alternatives and choose the optimal solution. Instead, they use "rules of thumb" that enable them to make quick decisions and cut through complexities. These rules create biases and quirks in our decision making.
There would seem to be no reason why the average politician should be immune from these biases. After all, there are some smart people in the financial markets and even they can make glaring mistakes.
For a start, there is the issue of confirmation bias. If people have a set view, they tend to look for evidence that confirms that view and to disregard any findings that contradict it. In the late 1990s, investors believed all the bullish stories about the profit potential of the internet; those who thought otherwise, like Warren Buffett, the US billionaire, were "dinosaurs" who "just didn't get it".
Similarly, political leaders believed the reports of Iraqi exiles and others who told them Saddam Hussein still had weapons of mass destruction. They dismissed the more cautious view of those such as Hans Blix, the United Nations' weapons inspector, believing such observers were cautious or naive.
A second behavioural finance trait displayed by political leaders was overconfidence. The majority of people believe they are better-than-average drivers. They are also overconfident about the extent of their general knowledge. One test, outlined in John Calverley's book Bubbles and How to Survive Them, asked people to estimate the length of the River Nile. Rather than being asked for a precise number, they were told to offer a range about which they were 90 per cent confident. Instead of guessing a very wide range, they gave very narrow parameters, and were wrong far more than 10 per cent of the time.
In the investment world, such overconfidence makes people believe in their ability to make successful decisions. They thus trade far too often. This problem particularly affects men and studies show that women, as a consequence, are better investors.
Political leaders were overconfident about their ability to assess intelligence reports, the ability of their armed forces to control the security situation in Iraq following the invasion, and the impact of the conflict on Islamic opinion.
Another problem that may have affected the political elite is anchoring. In financial markets, this usually relates to a fixation on a particular price level, either the price a t which the security was bought or its all-time high. Investors will be reluctant to sell unless one or the other is breached.
But anchoring can be related to past events, rather than a particular number. Generals suffer from the "fighting the last war" syndrome. At the start of the first world war, most people expected a short, fluid conflict, rather like the Austro-Prussian war of 1866. In fact, the development of the machine gun and barbed wire gave the advantage to the defensive forces. After the war, the French built the Maginot line in preparation for another defensive conflict, only for the development of aircraft and tanks to give the advantage to the attacking forces.
In 2002-2003, politicians become fixated on the idea that, as Saddam Hussein had had weapons of mass destruction in the past, therefore he must still possess them. In the US case, George W. Bush may have been anchored on his father's "mistake" in not having eliminated Mr Hussein in the first Gulf war.
The final behavioural trait shared by US and British politicians is known as loss aversion, or the "sunk costs" syndrome. Investors are reluctant to sell their loss-making positions, because that would force them to admit they had made a mistake. Instead, they hang on, hoping that markets will prove them right in the end.
Similarly, politicians will be reluctant to withdraw armed forces from Iraq, because that would suggest their own fallibility and that many lives had been lost (and much money spent) as a consequence. Voters may say that they would like politicians to admit when they have made mistakes, but in practice any leader who does so is presenting a gift to his opponent. It seems best to plough on with the same policy in the hope that "something will turn up".
The only escape from the sunk costs problem is to change the personnel. Businessmen in charge of loss-making projects they devised are reluctant to pull the plug, but their successors are happy to do so, knowing the old regime will take the blame. Fund managers regularly discard the bulk of their predecessors' portfolios.
Unlike businessmen and fund managers, however, politicians have to be voted into office. When it comes to wars, they have to tread carefully for fear of being dubbed "unpatriotic" - witness John Kerry's equivocal position, at least in the early part of his campaign, on Mr Bush's Iraq policy. This may be where politicians' behaviour diverges from investors': politicians almost always end up lumbered with some of the sunk costs incurred by their predecessors.
The writer is the FT's investment editor
---------------------------------
Citation: Philip Coggan. "Iraq Explained by Behavioural Finance," Financial Times, 15 October 2004.
Original URL: http://search.ft.com/ftArticle?sortBy=gadatearticle&page=3&queryText=%22Hans+Blix%22&id=041015010086
---------------------------------