Trust Behavior: The Essential Foundation of Securities Markets
Here’s the most important lesson from this paper:
“This suggests another fundamental difference between rational expectations investors and trusting investors. Where the former look to “the shadow of the future,” the latter care about “the shadow of the past.” Put differently, a rational expectations investor expects others to exploit her whenever possible. Accordingly she will always be forward-looking, trying, just as a chess player might, to anticipate other players’ opportunistic future moves. In contrast, trusting investors look to the past. If someone or something has always behaved in a particular way in the past, trusting investors assume that that person or thing will continue to behave similarly in the future, without worrying too much about understanding what drives the behavior in question.”
Abstract (Via SSRN)
Evidence is accumulating that in making investment decisions, many investors do not employ a ‘rational expectations’ approach in which they anticipate others’ future behavior by analyzing their incentives and constraints. Rather, many investors rely on trust. Indeed, trust may be essential to a well-developed securities market. A growing empirical literature investigates why and when people trust, and this literature offers several useful lessons. In particular, most people seem surprisingly willing to trust other people, and even institutions like ‘the market,’ in novel situations. Trust behavior, however, is subject to history effects. When trust is not met by trustworthiness but instead is abused, trust tends to disappear. These lessons carry significant implications for our understanding of modern securities markets.
Great Introduction (Via SSRN)
Burt Ross graduated from Harvard University in 1965. After working several years as a stockbroker, he ran for and was elected mayor of Fort Lee, New Jersey. Then Ross turned to commercial real estate. In 2003, he decided to sell some of his buildings and invest the proceeds, which amounted to more than five million dollars. Ross thought he was prepared for retirement. At least, he thought he was prepared until December 11, 2008, when he learned that his nest egg–which he had invested almost entirely in funds managed by the now-infamous Ponzi schemer Bernard Madoff– was gone. (Pulliam, 2008)
Favorite Excerpt (Via SSRN)
In a typical trust game experiment, each subject is given a certain amount of money (say, $10). The subjects are then divided up into pairs. One member of each pair is assigned to play the role of the “trustor” and is told that he has a choice to make: he can keep all of his money, or he can choose to deliver some or all of it to the other member of the pair, dubbed the “trustee.” Both subjects are told that if the trustor delivers any money to the trustee, the amount of money that is delivered (“invested”) will be tripled. Both subjects are also told that if the trustor chooses to send any money to the trustee—that is, to invest with the trustee–the trustee will then be faced with her own choice. She can either keep all of the tripled funds for herself, or she can choose to send some or all of those funds back to the trustor. It is quite clear how subjects who adhere to the rules of rational expectations theory would play the trust game. The trustor would refuse to invest any funds with the trustee, because the trustor would know that if he did so, a rational and purely self-regarding trustee would never send any money back. This is not, however, the way real people play a trust game.
In real life, people often choose to trust others, and trusted individuals often chose to act trustworthily. This was seen in one of the first published accounts of the results of a trust game experiment, a 1995 study by Joyce Berg, John Dickhaut, and Kevin McCabe. (Berg et al., 1995) Out of 32 pairs of subjects, 30 trustors chose to trust (that is, to send at least some of their money to the trustee). The majority of trustees then responded by behaving trustworthily. Twenty-four trustees sent back at least some of the funds they had received, and most sent back more than they had originally received from the trustor, thus ensuring that both parties profited from the trustor’s “investment.”