Wisdom Among the Wreckage, or How Neanderthals Killed Bear

Last week I wrote that lately it seems as if each day is accompanied by a new crisis on Wall Street. Of course this past weekend maintained the trend with the nearly inconceivable buyout of Bear Stearns, the 5th largest investment bank on Wall Street, for less than a Starbuck's latte or Big Mac per share. Remember that in early '07, you could've swapped one of your BSC shares for an Ipod Nano.

Let's be clear - this is not a "bailout" like I hear every three seconds on CNBC. It was a fire sale, vultures picking at a carcass. Is this the event that marks the bottom, or is it just the first in a lineup of more bad actors to walk the plank? Nobody knows and that is what is so unsettling.

In times like these I always like to search for wisdom that can help me understand why these events  occurred, and how I might personally avoid ever doing something so stupid. One of my favorite "handbooks for life" is Seeking Wisdom, from Darwin to Munger, by Peter Bevelin. I highly recommend it to anyone who seeks to understand human behavior and how to avoid cognitive mistakes that we are all prone to. Bevelin draws heavily from Buffett and Munger even though this is not a book on investing.

An early chapter is entitled "Psychological Reasons for Mistakes", in which Bevelin details 39 inherent cognitive tendencies that make us prone to error. As a former behavioral biologist, I strongly believe that much of our behavior today is controlled by responses burned into our brains early in our evolution.

In other words, the very same behaviors that helped Neanderthal man survive led to the credit crisis and the demise of Bear  (both last weekend and in the Pleistocene).

Let's examine Bevelin's first two reasons in light of the current financial debacle:

1: Association - this is simply Pavlovian behavior - if we associate a pleasant stimuli with an action we tend to do it again, and vice-versa. It doesn't matter if the action itself is good or bad, it takes on the characteristics of the associated stimuli. This is a deeply hard-wired response pounded into our psyches by evolution - our survival depended on it. Even the most primitive of organisms can be conditioned in this way, and we are no exception. Bevelin's advice: analyze actions and persons on their own merits alone. For example, "is levering up my capital more than 30-fold to buy opaque derivative instruments gets me praise from superiors and Wall Street analysts - it must be a good idea - I think I'll lever up even more!"

2: Reinforcement and Incentives: This is a HUGE one. It is an extension of number one, a conditioned response. If taking on huge amounts of leverage, or making questionable loans results in monetary rewards, the participants associate these "bad" acts with a "good" outcome, and they'll keep doing it. Therein lies the explanation for the current crisis in one sentence. If originating high-risk mortgage loans resulted in monetary reward, it was very easy for the participants to ignore the little voices in their heads telling them it was a bad idea. This incentive system traveled all the way up the food chain to the top of Wall Street.

As Charlie Munger said, "The iron rule of nature is: you get what you reward for". Reward cavemen with berries when they shake a bush, you'll get lots of bush-shaking. Reward brokers for loan volume, you get more loan volume. Reward people for generating earnings via increased leverage, you get more leverage.

Reward people for underwriting discipline, and none of this would have happened.

Philosopher Charles Frankel said, "A decision is responsible when the man or group that makes it has to answer for it to those who are directly or indirectly affected by it." Munger: " An example of a really responsible system is the system the Romans used when they built an arch. The guy who created the arch stood under it as the scaffolding was removed. It's like packing your own parachute."

In the unfortunate case of Bear Stearns, a whole lot of innocent employees and shareholders have been crushed by the "faulty arch" of a flawed incentive system. I know Neanderthals quickly learned that standing below an unstable pile of rocks was a bad idea. I am certain though that Wall Street won't be as "smart". Newly flawed incentive systems will be put in place to reward a new flavor of dangerous behavior. Unfortunately evolution has served to make us less aware of our base instincts and imbued many of us with the "it's different this time" gene.

If you'd like to get more in touch with you inner Neanderthal (and as such rise above most of Wall Street), look for future posts in my series on psychological reasons for mistakes.