Sunday, December 14, 2008

MISTAKE DU JOUR

Dec. 16 – Bernie Madoff With A Lot of Money – But How?

That’s the question on Wall Street these days as investors (not to mention federal prosecutors) try to figure out how so many supposedly smart people were duped out of so many billions of dollars.

One clue comes from William Goetzmann, a finance professor at Yale whose work was recently highlighted in The Wall Street Journal. Goetzmann found that hedge funds disclosing legal or regulatory problems and conflicts of interest ended up with lower future performance. But – and this is an important but – the disclosure of these risks had no impact on how much money flowed into the hedge funds. No impact! In other words, investors were getting useful information – they just weren’t paying attention to it.

Why would people make such a mistake? In part, because we don’t know how much to discount for conflicts of interest.

“Suppose you are a casual investor and you find out that IBM is getting consulting services from its auditor,” says George Loewenstein, a professor at Carnegie Mellon University in Pittsburgh who has studied conflicts of interest. “Or suppose your doctor recommends an X-ray, and then says he has an interest in the X-ray facility. In neither of those cases would you have a clue what to do. Would you not go get the X-ray? Is IBM worth half as much? 10 percent less? 5% less?”

Usually, he says, people don’t know what to do with the information.

“So what they do is ignore it.”

Which, as it often turns out, is a mistake.

For more on Loewenstein’s research, look
here.