In a truly bizarre story, CNBC is reporting allegations that traders at SAC Capital were forced to take female hormones in order to reduce their aggression, in hopes of improving trading performance. The allegations stem from a sexual harassment suit filed by one of the hedge fund’s junior traders, who claims that “the hormones caused [him] to start wearing dresses, avoid his wife’s touches altogether and allegedly begin a sexual relationship with his boss”. The story is all the more dramatic given that the trader’s boss is Ping Jiang, a top trader with a reported income north of $100 million a year.

Sexual harassment cases are nothing new on Wall Street, but CNBC has uncovered new details of one of the most salacious cases to hit a big trading house in a long time.

The case involves a sexual harassment lawsuit filed by a Andrew Z. Tong, a former junior trader at SAC Capital, the powerful Greenwich, Conn., hedge fund, against one of SAC’s top producers, a trader named Ping Jiang.

A New York State judge has sealed the case and sent the lawsuit into arbitration, where both sides would battle it out in private. He even cancelled oral arguments that were scheduled for Thursday following an appeal by Tong’s lawyers, who want the case to remain in state court.

The judge said he sealed the details of Tong’s allegations contained in the lawsuit because it is not in the public interest to disclose the salacious nature of the complaints. CNBC has learned the suit includes the following allegations made by Tong against Jiang:

• After being hired at SAC, Tong alleges that Jiang came to him and told him he had a trading method in which his traders must not be too aggressive; that traders must be more effeminate and to do so, he directed Tong to begin taking female hormones.
• Tong says he then took the female hormones that he bought on the black market.
• Tong then alleges he suffered emotional and physical distress. The hormones, he says, caused him to begin wearing women’s clothes. He also could not perform sexually with his wife, who wanted to have a baby.
• Tong says the sexual harassment included sexual relations between the two men.

While the salacious details will certainly generate a lot of press, could it really be that giving your male traders estrogen Kool-Aid would actually improve their market performance? Let’s review the research.

In many contexts, men have been found to be systematically more overconfident than women. Among these is “Gender and Overconfidence” by Bengtsson, Persson, and Willenhag. The authors studied a Stockholm University economics exam which has an optional extra credit question, which only applies to a student’s grade if they did sufficiently well on the rest of the exam. While women overall are more likely to pass the exam, only 83.8% of them attempt the extra credit question, compared to 87.1% of men.

This type of overconfidence can induce many decision making biases which can depress investment returns. Among these are a tendency to trade too often, generating excessive trading costs, and attributing random market movements with one’s own predictive skill, which impairs learning. In a study of trading activity by 35,000 households with a large brokerage house, Barber and Odean report that due to overconfidence, men trade 45% more than women. This excessive trading reduces men’s average net returns by 2.65% a year, compared to a 1.72% reduction for women.

Let’s do a thought experiment. SAC Capital has about $14 billion in assets under management, and reportedly returned 34% in 2006. While the type of trading activity going on at SAC is far different from the household brokerage trades in the dataset studied above, let’s assume for a moment that SAC could capture the 0.93% male-female performance difference if only its traders all behaved more like women. This small performance edge would improve the fund’s returns by OVER A BILLION DOLLARS in five years.

Perhaps it’s no mystery then why a top trader would want his underlings to trade more like women. Maybe the real question then is why a hedge fund would think it was better off taking the substantial legal risk of forcing employees to take drugs against their will, as opposed to working to hire actual women — overconfidence, perhaps?

Read more:

• CNBC: Detail emerge in SAC Capital Sex Harassment Case
  
• Gender and Overconfidence, by Claes Bengtsson, Mats Persson and Peter Willenhag
• Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment, by Brad M. Barber and Terrance Odean

Earlier:

• Mars and Venus on Wall Street
• All posts tagged “gender”
• All posts tagged “overconfidence”

Conventional economic models presume that raising the price of a product will cause it to be used less, as this will dissuade some price-sensitive consumers from purchasing the product. Young economist Jesse Shapiro at the Becker Center on Chicago Price Theory investigates whether distributional and psychological factors might cause product usage to go up as its price is raised, contrary to conventional theory. This question is especially relevent to many global public health organizations considering what price, if any, to charge the poor for drugs, vaccinations, anti-malarial products, and other goods and services.

Many social programs focused on improving health in developing countries require active participation .Unlike a one-time vaccine, products ranging from condoms to insecticide must be used regularly in order to have any health benefit. The crucial role of household behavior in making such products work has led practitioners to search for new ways to ensure regular use among households receiving much-needed health products.

Shapiro went to Zambia to study these issues in the context of the sale and usage of Clorin, a home water purification product. Two distinct effects were studied. First, does charging a higher price target distribution at those who are willing to pay more because they intend to use the product more? Second, does the act of paying more itself induce people to use the product more, due to the sunk cost effect, which might cause people to psychologically justify the purchase price through increased use?

In order to study whether charging more for Clorin results in greater use, the authors designed an experiment that would separate two effects of prices on product use. On the one hand, charging a higher price may help target distribution of the product to those who intend to use it most. On the other hand, the act of paying—or the amount paid—may exert a direct influence on use if households feel they must use a product to make the best use of the money they spent. These two effects—which the authors respectively call the “screening” and “psychological” effects of prices—combine to determine the effect of prices on product use.

The authors find strong evidence that higher prices screen out less intensive users of Clorin. For a given transaction price, increasing the offer price by 10 percent results in a 3.6 percent increase in reported use among buyers.

…

Put differently, the authors find that the screening and psychological effects allow a firm or government to achieve the same level of Clorin use while charging a higher price. This, in turn, means that the Clorin program can produce greater revenue, which can in turn be reinvested in advertising to promote use, or can be redirected to other valuable social programs.

Understanding how these effects work will be very important for organizations looking to maximize the effectveness of their public aid and wondering how much to charge for the services they provide.

Understanding the screening and psychological effects of prices is critical to resolving public policy debates over the appropriateness of user fees for access to social products and services.

Ashraf, Berry, and Shapiros findings have important implications for economics and psychology, as well as for private and public sector industries in which product use is an important consideration.

“Our findings offer a new way to think about the pricing controversy,” says Shapiro. “Charging higher prices for health products does have an obvious downside, which is that fewer people will get access, but the benefit is in targeting the distribution of the product to the people most likely to use it, as well as greater revenue for social programs. These issues need to be weighed against each other when making policy decisions about setting prices.”

Watch the video at the link below to hear Jesse describe his research in Zambia. He also discusses applications to media and advertising, in particular the question of whether giving a publication such as a newspaper away for free induces people to pay less attention to it, thereby reducing the value the audience has to potential advertisers.

Read more: The Economics of Pricing: Can Higher Prices Stimulate Product Use?

When making decisions in the real world, there is often a tradeoff between speed and accuracy. There is a whole spectrum of approaches that can be brought to bear on a problem, ranging from a simple gut feel decision to sophisticated statistics like running a nonlinear regression. If we have the necessary resources, is the latter always better? The Boston Consulting Group’s Strategy Institute describes what they call “fast and frugal heuristics”, and explains the situations in which such simple decision making strategies can be more effective than even sophisticated analytical techniques.

Since the Enlightenment, the main model of rational judgment in an uncertain world has been probability theory. The laws of probability, however, do not deal with the constraints in time, information, memory, and other resources that are characteristic of the decision making of actual humans (and machines). As a consequence, the underlying vision of rationality has been termed “unbounded rationality”—an omniscient and omnipotent fiction with little or no regard for the limitations in time, knowledge, and computational capacities that humans face. To make rationality more human than God-like, the concept of “bounded rationality” has been proposed. The key difference between unbounded and bounded rationality is the concept of limited search, to be defined by a stopping rule. The vision of bounded rationality, however, is not of one kind.

Rationality comes in many forms. The first split in Figure 2 separates models that assume the human mind has essentially unlimited demonic or supernatural reasoning power from those that assume we operate with only bounded rationality. There are two species of demons: those that exhibit unbounded rationality, and those that optimize under constraints. Optimization under constraints means optimization given various constraints, that is, limited resources such as attention, time, money, or information. The vision of constrained optimization is that minds would calculate the optimal trade-off between the benefits and costs of further search at regular time intervals, and stop search when the costs would outweigh the benefits. The rule “stop search when costs > benefits” sounds plausible at first glance, but a closer look reveals that this… can demand even more knowledge and computation than unbounded rationality.

There are also two main forms of bounded rationality: satisficing heuristics for searching through a sequence of available alternatives, and fast and frugal heuristics that use little information and computation to make a variety of kinds of decisions.

An example of an ignorance heuristic in action:

Let me illustrate the way this heuristic works with one example: Which US City Has More Inhabitants: San Diego or San Antonio? We posed this question to students at the University of Munich and the University of Chicago. The latter, who have a reputation for being among the most knowledgeable in the US, were correct 62% of the time. Yet 100% of the Germans got the correct answer 100% of the time. How did the Germans infer that San Diego was larger? All of the Germans had heard of San Diego, but many of them did not recognize San Antonio. They were thus able to apply the recognition heuristic and make a correct inference. The American students were not ignorant enough to be able to apply the recognition heuristic.

Read more: Fast and Frugal Heuristics: Simple, Adaptive Decision-Making Strategies Leverage Ignorance To Make Us Smart

The rise of e-commerce has provided companies with rich new sources of information on their customers, based on the clickstreams that users generate as they navigate through a commerce site. This finely grained data brings with it a host of potential new ways to segment customers and tailor a product or service to their specific interests and priorities. Ross Parker has found an interesting example of one such tactic on an online travel site. The site changes the price of a hotel stay displayed to the user based on whether the user sorts the results by lowest price first, or highest price first. The logic seems to be that customers who sort the results from high to low are less price-sensitive than others, and might be willing to pay a higher price for the same hotel room.

The clever idea of travel sites seems to me not to discriminate on any information you provide but rather on information that you request and, crucially, how you request it. Specifically, they know if you have chosen to sort prices ‘lowest first’ or ‘highest first’. This information can be used to the companies’ advantage.

If you sort your search results so as to see the cheapest option first, you’re probably looking for a budget hotel and a good value break. To get your custom, the firm will have to be competitive at the lower end, with headline grabbing rates - ‘Prices from only £x!’. To get you to make them a little more margin, they’ll want to tempt you up the scale a little bit - ‘For only £10 extra you could upgrade to…’. So a pricing structure for this sort of customer would be cheaper for the same reason that student cinema tickets are cheaper: the customer is more sensitive to price.

Conversely, if you sort your search results ‘highest first’, you aren’t looking for a bargain break. You may still want a good deal, but you’ve already indicated that you’re willing to pay for a good holiday and money is not your main concern. So you’d expect prices here to be a little dearer, especially at the top end. Furthermore, you want these people to think that they wouldn’t be saving much going for a cheaper hotel, thus helping them rationalise their choice of a top hotel.

As retailers become increasingly sophisticated at leveraging the massive databases of customer information they already have, can more of these types of tactics be far behind? In many ways the internet is providing the laboratory that economists have never had–a tool for running experiments, which is giving a more thorough understanding of consumer behavior and a venue to gather empirical evidence for new and existing theories.

Read more: Price discrimination in online travel firms

via Marginal Revolution

The Edge magazine has an annual tradition of asking an impressive roster of scientists and intellectuals a single big question. This year’s question: “what are you optimistic about?” Nassim Taleb–whose ideas frequently appear here at Micromotives–makes some typically intriguing and contrarian comments about the deep value of randomness and uncertainty, conditions more often seen as a liability than an asset in today’s challenging decision environments.

I have seen in Richard Dawkins’ work many references to the difficulty people have, when looking at an animal, in accepting that it is not the product of a top-down design, but the result of a random process — more exactly the upper bound of a random process, in which (roughly, and only roughly) the most successful mutations tend to make it. Yet my problem is that when those who accept the evolutionary argument look at a computer, at a laser beam, at a successful drug, at a surgical technique, at the spread of a language, at the growth of a city, or at an commercial enterprise, they tend to fall for the belief that its discovery or establishment partook of some grand design. And, in hindsight, some “explanation” will be given as to why it happened: there was a plot — it could not have been an accident.

Alas, we are victims of the narrative fallacy — even in scientific research (but while we learned how to manage it in religion, and to some degree in finance, we do not seem to be aware of its prevalence in research). The pattern-seeking, causality producing machine in us blinds us with illusions of order in spite of our horrifying past forecast errors. I hold that not only discoveries are also largely the result of a random process, but that their randomness is even less tractable than, and not as simple as, biological evolution. While nature might produce milder form of stochasticity, the environment for manmade discoveries is governed by a far, far more severe, wilder form of processes, those called “fat tailed”.

Against what one might expect, this makes me extremely optimistic about the future in several selective research-oriented domains, those in which there is an asymmetry in outcomes favoring the positive over the negative — like evolution. These domains thrive on randomness. The higher the uncertainty in such environments, the rosier the future — since we only select what works and discard the rest. With unplanned discoveries, you pick what’s best; as with a financial option, you do not have any obligation to take what you do not like. Rigorous reasoning applies less to the planning than to the selection of what works. I also call these discoveries positive “Black Swans”: you can’t predict them but you know where they can come from and you know how they will affect you. My optimism in these domains comes from both the continuous increase in the rate of trial and error and the increase in uncertainty and general unpredictability. I have seen in Richard Dawkins’ work many references to the difficulty people have, when looking at an animal, in accepting that it is not the product of a top-down design, but the result of a random process — more exactly the upper bound of a random process, in which (roughly, and only roughly) the most successful mutations tend to make it. Yet my problem is that when those who accept the evolutionary argument look at a computer, at a laser beam, at a successful drug, at a surgical technique, at the spread of a language, at the growth of a city, or at an commercial enterprise, they tend to fall for the belief that its discovery or establishment partook of some grand design. And, in hindsight, some “explanation” will be given as to why it happened: there was a plot — it could not have been an accident.

Alas, we are victims of the narrative fallacy — even in scientific research (but while we learned how to manage it in religion, and to some degree in finance, we do not seem to be aware of its prevalence in research). The pattern-seeking, causality producing machine in us blinds us with illusions of order in spite of our horrifying past forecast errors. I hold that not only discoveries are also largely the result of a random process, but that their randomness is even less tractable than, and not as simple as, biological evolution. While nature might produce milder form of stochasticity, the environment for manmade discoveries is governed by a far, far more severe, wilder form of processes, those called “fat tailed”.

Against what one might expect, this makes me extremely optimistic about the future in several selective research-oriented domains, those in which there is an asymmetry in outcomes favoring the positive over the negative — like evolution. These domains thrive on randomness. The higher the uncertainty in such environments, the rosier the future — since we only select what works and discard the rest. With unplanned discoveries, you pick what’s best; as with a financial option, you do not have any obligation to take what you do not like. Rigorous reasoning applies less to the planning than to the selection of what works. I also call these discoveries positive “Black Swans”: you can’t predict them but you know where they can come from and you know how they will affect you. My optimism in these domains comes from both the continuous increase in the rate of trial and error and the increase in uncertainty and general unpredictability.

Taleb’s optimism about the value we can derive from uncertain environments has parallels with the use of real options to value and analyze the payoffs from different potential courses of action. We know from the Black-Scholes model in financial theory that the value of a financial option (e.g. a call or a put on a stock) increases with the volatility of the underlying equity. Real options are essentially investments which give one the opportunity, but not the necessity, of pursuing further courses of action down the road. Similarly to a financial option, a real option increases in value the more uncertain, or random, an environment we are operating in. It has become cliche at this point to describe the current global business environment as increasingly rapid and complex, but what we can learn from these generalizations is that the value of “keeping your options open” is ever increasing.

Real options sit at a rich crossroads between financial theory and decision theory; expect more discussion of real options here soon!

Read more: Nassim Taleb: The Birth of Stochastic Science