Book Review: Going to Extremes

Cass Sunstein writes, “The economic crisis that began in 2008 was a product, in significant part, of a form of group polarization, in which skeptics about the real estate bubble, armed with statistical evidence, did not receive a fair hearing or were in a sense silenced.” This raises a couple of immediate questions. For example, how do group dynamics influence individual and group (that is, market) decisions? What can astute investors or financial decision makers learn from Sunstein that will improve the way they process information and arrive at conclusions?

Going to Extremes is an excellent study of the conditions that drive events like the financial crisis, and it gives rise to at least two direct applications for the investment industry. The first of these pertains to the impact of politics on economic decisions. Think GM, Chrysler, Bank of America, and Citibank. Those who understand political methodologies and agendas will form a more accurate assessment of which political environment could be most (or least) conducive to certain investment decisions. The second application of Sunstein’s theories to the financial sector involves risk. Regulators and business organizations that perceive the impact of group composition on the degree of risk taking present in the decision-making process will be able to optimize the design of their teams.

Sunstein lays out a number of key concepts, exploring the implications of each, and suggesting countering actions for cases in which those implications are potentially adverse. He deals, for instance, with group polarization. This concept arises from studies of the effects of opinionated discussion on people inclined to take risks. After group discussions, the studies found, such individuals became significantly more disposed to risky decisions. He also investigates rhetorical advantage, a concept applied to jury awards and the idea of altruism. Studies of juries suggest that punitive awards are likely to be larger after group discussions take place. Regardless of the circumstances of a case, the fact that it’s easier to justify a large award than defend a small one gives rise to an artificial advantage for higher awards. In another scenario, groups that discussed how much money they should “share” with others were more generous than the individual members would have been outside the group environment. In this instance, it appears that the generosity is motivated by the desire to be perceived as altruistic by others in the group.

Sunstein also explores three techniques for countering situations that have the potential to encourage groups to adopt more extreme positions. First, there’s traditionalism, which proposes that reasonable citizens aware of their limitations will effectively delegate a good deal of authority to their traditions, and will defer to the status quo. Traditionalism may apply unevenly across demographics—the “me generation,” for example, might be relatively unaffected by this countermeasure. Second is consequentialism, which suggests that group decisions may be influenced by a deliberative review of the specific results of a particular decision—costs, scenarios, and so on. Consequentialism more or less boils down to the idea that a solid reality check can mitigate overly extreme degrees of risk or identify possible negative outcomes. Finally, there are checks and balances. This technique makes reference to the benefits of “deliberative democracy” and attempts to combine a process of reflection and discussion with a focus on accountability. This countermeasure can be applied not only to systems of government, but to the establishment of prudent practices in financial decision making as well.

In addition to these formal countering techniques, Sunstein also believes in the “wisdom of crowds.” He devotes a number of pages to explaining why that concept has substantial statistical validity, particularly when there is significant diversity in the composition of the crowd. Those in charge of putting together investment teams would be well advised to include thinkers who can offer downside views to be vetted during the group’s decision-making process.

As far as the application of Sunstein’s work to the financial services sector goes, the research studies summarized in the “Findings of Group Polarization” appendix provide excellent resources for investigating the effect group dynamics can have on risk management. While Going to Extremes won’t be found in bookstores’ finance and investing sections, it’s a valuable survey of research pertinent to managers in various areas of finance, and it suggests a range of practical, utilizable approaches to improving decision-making processes.

–A. Mark Harbour, CFP, CFA, CIMA, is a financial advisor in Los Angeles.