Mind Over Money


Suppose that you have a choice. You can accept a sure $500 or you can face 50-50 odds that you will either win $1,000 or nothing at all. What would you do if you actually faced this situation?

Or suppose that you are in the unfortunate situation where you have lost $500. However, instead of accepting this loss, you can face 50-50 odds that you either lose $1,000 or you lose nothing? What would you do if you actually faced this situation?

In the study of behavioral finance, we consider such questions. Using psychology to understand how people behave when they make financial decisions is an approach that is revolutionizing the way that finance is both taught and practiced.

In most universities, finance has been taught as if psychology plays a minor role in financial decision-making. But at Santa Clara University, behavioral finance has been part of the curriculum for more than 20 years. Together, for two decades, we have used an interdisciplinary approach that brings psychology to bear on the traditional approach to finance, and highlights the role that values and ethics play in the behavior of investors, analysts, and corporate executives.

Psychology and risk

When asked the two questions above, more than half of our students say they would take the sure $500 instead of taking a chance on winning $1,000. However, more than half of students would take the chance of losing $1,000 instead of accepting a sure loss of $500.



The interesting thing about gains and losses is that they have to be measured relative to some reference point. And often that reference point is arbitrary. For example, public health officials who are combating an epidemic such as SARS can measure the effectiveness of a treatment in either lives saved or lives lost. The reference point in one case is everybody dying, and the reference point in the other case is nobody dying. Psychologists have shown that public health officials are more prone to adopt conservative policies when they think in terms of lives saved instead of lives lost.

Psychology and fairness: Reference transactions and losses

When it comes to the way that people think about the fairness of financial transactions, reference points or reference transactions play an important role. Think about what happens to prices for items such as electric generators after a major storm or power outage. Those prices often rise, sometimes dramatically. Consumers often respond by complaining about price gouging. From their perspective, the fair price was the price established before the storm. Relative to the pre-storm price, they perceive themselves to be facing a loss.

The point is not just that consumers pay a high price that has come about because of increased demand, it is that in paying the high price, they experience the pain of a loss. People do not always experience a loss when they pay a high price for something, such as real estate in an expensive location. However, if they feel they have been overcharged, that is another matter.

In our own writings, we suggest that psychological notions of fairness play critical roles in determining the financial regulations that govern behavior in financial markets. For example, some investors might feel that they have been treated unfairly if they have received false information. For them, the reference transaction involves having received information that is true, and so they see the actual situation as a loss relative to what they imagine would have happened in the reference transaction.

By the same token, some investors might feel they were treated unfairly if they did not have access to the same information as did some other investors. For these investors, the reference transaction involves all investors having access to the same information.

The notion of access to information is sometimes connected to the relative power of the transacting parties. Some individual investors whose stocks declined in price may feel that they were at a disadvantage relative to large, powerful institutional investors.

Insider trading

As a hypothetical, John Burr is a shareholder of the Beta Corporation. He analyzed the financial prospects of Beta using public information and concluded that its stock is overpriced. Burr decided to sell his shares.

Almost all of the people we surveyed, 94 percent of students and 99 percent of investment professionals, judged Burr to be fair. The reference transaction is a transaction that conforms to community rules of fairness, and selling shares based on an analysis of public information conforms to these rules. In contrast, selling shared-based on inside information violates these rules.

Or consider lawyer Paul Bond, who overheard a conversation between fellow lawyers about their work on behalf of a company that planned to acquire another company. Bond proceeded to buy shares of the company to be acquired and profited when news about the acquisition became public and the price of shares of the acquired company zoomed.

An overwhelming 96 percent of investment professionals judged Bond’s behavior unfair, but students were much more lenient toward him-only 64 percent of them judged his behavior unfair. The perceptions of the judges on the U.S. Supreme Court are much closer to those of investment professionals than to those of students. The Supreme Court ruled, in a case similar to this vignette, that Bond violated insider-trading laws.


The difference in perceptions between students and investment professionals highlights a great danger facing students who enter the business world. Such students might find themselves in serious trouble if they follow their lenient attitude toward insider trading with action. We, their teachers, must alert them to community rules of fairness so they do not violate them.

All people tend to travel in narrow social and professional circles, so even experienced investment professionals get into trouble when they focus on their own rules of fairness or those of their narrow community, failing to perceive the rules of the wider community. Consider the case of Christina Morgan, the managing director of investment banking at Hambrecht & Quist in 1997. Michael Siconolfi, a Wall Street Journal reporter, asked Morgan about the practice of “spinning,” in which investment bankers allocated lucrative shares in initial public offerings (IPOs) to executives they courted. For example, an investment banker courting the business of Joseph Cayre allocated him 100,000 shares of Pixar Animation Studios when Pixar went public. Cayre sold the shares that day for a $2 million profit.

Christina Morgan saw nothing unfair in spinning, likening it to such perks as free golf outings. “What we’re talking about is trying to solicit business,” said Morgan. “What do you think about taking them out to dinner? What do you think about that? We throw lavish parties with caviar. Is that not trying to influence them, their behavior? I suggest that it is.” Allocating hot IPOs to corporate executives, says Morgan, “is not illegal, it’s not immoral, it’s a business decision.”

Some Wall Street Journal readers disagreed vehemently with Morgan’s perception of the rules of fairness. “Are [investment bankers] really unable to see any distinction between a golf outing or a dinner with a favored client and a payoff of several hundred thousand dollars?” wrote James Penrose. “I can only express disbelief at the greed and avarice on one side of the transaction and the total lack of business ethics on the other,” wrote R.G. Kirby.

Christina Morgan failed to perceive the rules of fairness as perceived by people outside her social and business circle and paid a price for her failure. Her Hambrecht & Quist bonus was cut in half. The company paid a price as well. Merrill Lynch was planning to acquire Hambrecht & Quist but backed away when the spinning news made its way into the pages of the Journal.

Corporate scandals

Many of the people involved in the corporate scandals at Enron, WorldCom, and Arthur Andersen were well-respected pillars in their communities. Many were active as leaders in their churches and synagogues. Some were Jesuit educated. So, what went wrong? What were the psychological states of the executives whose behavior gave us these scandals?

Behavioral finance suggests that reference points played a critical role. For example, the accounting firm of Arthur Andersen had a policy that required auditors to double the amount of revenue they were bringing into the firm, through non-auditing fees. Such a policy change is tantamount to raising the referencing point, leading accountants to view as a loss what would formerly have been considered a gain.

Think back to the psychological questions about gains and losses posed at the beginning of the article. The answers show that people take more chances when they are likely to experience losses. In Arthur Andersen’s case, some of its auditors engaged in aggressive accounting practices, especially at Enron. Similarly, executives at Enron and WorldCom set themselves very lofty goals. Those goals gave rise to high reference points, with the result that failing to achieve those lofty goals was experienced as a loss. Again, aversion to losses typically leads people to take chances that they would not in other circumstances.

The behavior of the executives and auditors at Enron, WorldCom, and Arthur Andersen is tantamount to cheating. These executives and auditors cheated investors who relied on the information they provided as being transparent and truthful.

Of course, cheating is not unique to executives. Therefore, we try to help students understand the psychological pressures associated with corporate cheating by drawing the analogy to cheating in an environment that they have directly experienced.

Is there a common factor linking student cheating to executive cheating? Indeed there is, and it is ambition. High aspirations for grades can eventually “morph” into high aspirations with respect to career advancement. Excessive ambition produces excessively high reference points, leading people to take chances that in other circumstances they would not.

The students of today will be the executives of tomorrow. We strive to educate them to appreciate not only the intellectual challenges they will confront in their future careers, but the emotional and ethical challenges as well.

Kaleidoscope Of Humor


Value Proposition



Pondering the future effects of a year spent in quarantine.

Taking Note
