The latest entry in the Chicago Graduate School of Business podcast series is a talk given by Freakonomics author Steven Levitt. Levitt uses a number of the business case studies he has analyzed to illustrate a few broad points about business. His main argument is that in the business world (not to mention life in general) the most difficult decisions are those that we don’t get any meaningful feedback on. Two examples he gave were determining profit-maximizing pricing, because companies are typically loath to change their prices often or risk alienating customers by charging them differently for the same good, and advertising, because few organizations have solid ROI numbers on their advertising expenditure. Those who have read Freakonomics (seems like nearly everyone at this point, according to the bestseller charts) won’t be surprised to hear that Levitt recommends finding ways to build feedback into the decisions you make and implement, most notably by designing effective ways of running experiments and generating data.

Here are a few of his notable comments:

• Demand curves, which are a staple of the type of microeconomic analysis taught in school, are very rarely known in real world situations. Even when we observe changes in the level of demand after a price change, it’s not clear whether we’re learning something new about the existing demand curve or if we’ve simply moved to a new curve based on other market factors.
• When MBA students are asked to rank the importance of the subjects they studied, two years out of school, they typically put organizational behavior classes dead last. However, 10 or 15 years out of school, they typically put them first. Their focus has shifted from simply determing optimal corporate behavior to actually getting those behaviors adopted amidst all of the messy realities of modern organizations.
• Levitt claims that one of the few business people he has successfully convinced to adopt the unconventional Freakonomics approach to decision making is a Chicago prostitute who offered to share the data she had collected on her “transactions” with customers over the years. Levitt was interested in understanding how she set prices, and how her thought process compared to that predicted by the completely rational homo economicus of the traditional economics literature. The simple heuristic Levitt proposed for evaluating her pricing was this: when the phone rings with a call from a potential client, does it make her happy, or sad? When she told him that it made her a little sad, he responded that she must not be charging enough; if she was charging enough, the “costs” of lost free time and potential unpleasantness would be more than made up for by the gains of revenue from an additional client.
• Pilot programs are much more effective than focus groups according to Levitt, for the following reasons:
• The focus group process itself brings a level of scrutiny to people’s decision making that can cause them to alter their behavior.
• Forceful individuals can effect group dynamics enormously in a focus group situation, distorting the outcome and causing unanimity which is uncommon in the real world. Levitt once told a Hollywood executive that if he was allowed to sneak one or two “confederates” into an advance screening, he thought he could significantly alter the ratings the move got from the screening audience as a whole. His hypothesis is that the presence of a loud, boisterous laugher at a comedy, or conversely of a weepy crier at a sad movie, is enough to broadly change other audience members’ perceptions of the quality of the movie.

Read more, and listen here: Audio coverage of Steven Levitt, Professor of Economics, speaking at the Executive MBA Kick-off week at Gleacher Center.

Last week I had the opporunity to see a presentation given by Dan Reingold, author of the recent book Confessions of a Wall Street Analyst: A True Story of Inside Information and Corruption in the Stock Market, which details his experiences as a telecom analyst for a number of the major investment banks on Wall Street. The talk primarily covered the question of analysts manipulating their recommendations in order to boost profits for their bank, and as a top analyst himself, Reingold was in a central position to watch (and participate in) the problems as they unfolded throughout the dot-com boom.

According to Mr. Reingold, there are three primary factors which work to compromise the objectivity of analysts’ ratings and recommendations. The first is peer pressure from their banking colleagues. Suppose an analyst has a coworker on the investment banking side who is working on a deal with Company XYZ to do an IPO for them which will generate substantial fees for the bank. That coworker is likely to place alot of pressure on the analyst not to make negative remarks about Company XYZ’s prospects publically, which would likely anger the potential client and threaten the deal and associated revenue. The second factors is pure self-interest or greed. According to Reingold, it is a common practice today for analysts to be offered compensation packages which explicitly include a percentage of the investment banking revenue in their target industry. If an analyst has this type of compensation package, they clearly have a strong financial incentive to skew their recommendations in the direction which will help generate the most revenue from the other side of the bank. Finally, Reingold suggested that simple human error, in combination with lax independence rules, works against a fair and objective analyst marketplace. When analysts are brought “over the wall” to consult on pending investment deals, they often are made privy to insider information that is valuable to potential investors. Reingold said that once an analyst knows certain inside information about specific companies within their target industry, it is very difficult to prevent that information from coloring his or her otherwise independent judgement, or even subconsciously leaking information to clients.

Reingold was also critical of the recent resolution of Attorney General Eliot Spitzer’s investigation into conflict of interest problems at the major investment banks. A few points of interest:

• Over a 4-5 year period, about 10 of the top banks made $80 BILLION in profits. The resolution calls for those banks to collectively pay $1.4 billion in fines. A fine which is only a tiny percentage of profits may send the message that crime pays and fines are a necessary cost of doing business on Wall Street.
• Jack Grubman, a high profile target of the investigation, was ordered to pay $15 million in fines personally. His severance package from Citigroup totaled $34 million. Those numbers don’t seem to provide a very strong personal incentive for avoiding conflicts of interest.

Reingold went on to offer his suggestions for a stronger set of reforms which would, in his view, do more to curb conflict of interest problems. I’d like to ask a somewhat different question — is it possible to estimate how big of a problem these cases represent, and to what extent Wall Street analysts are biased? Some statistical work has been done on measuring the significance, or accuracy, of analyst buy and sell recommendations, and it shows that sell ratings are significantly more informative than buy ratings. This gives some evidence for analyst bias, although there are other potential explanations for the data. Perhaps analysts are prone to irrational streaks of optimism, causing them to issue unwarranted buy ratings. I float that possibility somewhat in jest, but readers of this blog know that humans face many psychological and cognitive biases which can cause them to make errors in decision making, and even though analysts are well-paid professionals, they are not immune from these biases altogether. Perhaps a well-crafted statistical study can shed more light on the objectivity of individual analysts.

Previously: Analyst Recommendations and Insider Trading

UPDATE: In the comments, “bronxite” suggests another bias that could be effecting the skew in buy/sell ratings, which is that analysts have an endogenous preference to cover more exciting, growth-oriented companies. More detail can be found in the paper Do Security Analysts Speak in Two Tongues? by Ulrike Malmendier of Stanford and Devin Shanthikumar of Harvard. A related issue is what I think is an innate human distaste for naysaying. Most people would shy away from a position which required publically badmouthing other organizations day in and day out. We can see similar psychological factors at play in the persistent suspicion and hostility against short sellers in the market, who are portrayed as vultures preying on the misfortune of others.

What are the odds that the two books on economics I am reading right now, one published in 1989, the other published just months ago, would both begin with the same quotation from the Argentinian essayist and fabulist Jorge Luis Borges? The specific quotation is taken from the opening of Borges’ 1962 essay “The Fearful Sphere of Pascal”, and reads:

It may be that universal history is the history of a handful of metaphors.

The books are: More Heat than Light: Economics as Social Physics, Physics as Nature’s Economics by Philip Mirowski, and The Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics. I’ll have more to say about both as I progress…

In the July 10/17 issue of The New Republic, Michael Porter and Elizabeth Olmsted Teisberg present their prescription for a more effective and efficient health care system based on measuring and reporting outcomes on a provider basis — a common-sensical approach which nonetheless is rarely seen in the US health care system.

Most people have better information about their restaurants, cars, and sellers on eBay than they do about their medical care. And the information that is available — health plan ratings, subscriber satisfaction surveys, and rankings based on doctor or hospital reputation — do not really measure health outcomes.

This lack of transparency means that health care providers aren’t really competing on what matters most — the value they provide. We can define the value of a procedure being performed by a provider as the effectiveness of that procedure divided by how much it costs. This is the measure that both end consumers and insurers really care about; getting the highest quality treatment at the lowest price. Furthermore, competition among providers on the basis of value is what will drive the discovery and adoption of more effective standards and procedures, which is of great benefit to society as a whole. So what’s holding us back?

Measuring results is the single-most important step in transforming health care, not only in the United States, but in other countries, too. So what’s standing in the way of developing more such measures? Some providers have resisted outcome reporting, which means that mandatory reporting might be necessary… Another impediment has been the fear, by insurers, amon others, that publicizing outcome measures would lead patients to demand care from the most expensive doctors and hospitals. Biut, by and large, the best health care providers are the most efficient. They make fewer errors and enable faster recovery and less long-term disability. They also tend ot manage diseases better, so that fewer patients have full-blown, acute crises. And this, ultimately, is the mindset that should define our health care system: Better health outcomes do not have to cost more money. On the contrary, they may end up costing less.

The New Republic article is adapted from their recent book Redefining Health Care: Creating Value-Based Competition on Results.

Continuing on yesterday’s theme of sound-based interfaces for transmitting financial information, here’s another proposed tool which lets users listen to market activity. The SpreadPlayer, designed by the interdisciplinary art group Derivart, is a portable mp3 player paired with custom software which translates data about market indices into audible changes in the frequency and volume heard throught the player.

SpreadPlayer relies on sound to revise the concept of financial visualization. The installation translates concepts used in finance into auditive ideas such as frequency and volume. It transmits the state of the stock market through sound, liberating the user’s eyes and stimulating alternative senses such as the ear, the musical sense or the sense of rhythm.

The installation includes an MP3 player, a proprietary software package, a real time connection to the capital markets and the packaging of the product. The player displays variations in prices of specific stocks, as well as fluctuation in indices in real time. It offers the option of modifying the sound output with the “melody” tool (which changes the average price of a stock), cancelling the “noise” of a stock (eliminating its financial peaks) or calculating an average of the up and down movements. Visually, it evokes the aesthetics of other players (iPod, Creative Zen, etc.) as well as their software (iTunes, Windows Media Player), emphasizing the idea of a mass market product.

SpreadPlayer offers a new concept, the notion of “auditive representation”. It reintroduces, at an individual and portable level, the usual reliance of brokers of multi-tasking while working from trading rooms. Traders, for example, use their sight to watch the piece of the market in which they are buying or selling, but remain connected to the broader market by overhearing the conversations of their fellow traders. By reintroducing sound in the individual experience of the market, SpreadPlayer redefines the traditional concept of financial visualization.

Derivart’s resident economic sociologist is Daniel Beunza, who just joined the faculty of the Columbia Business School as an Assistant Professor. For more information on Derivart, including some of their other projects, check out this post at We Make Money Not Art: Art, Finance and Technology.