Saturday, October 15, 2011

Temper Your Trust To Avoid Financial Rip-Offs

Trust may be "the all-powerful lubricant that keeps the economic wheels turning," but Bernie Madoff's Ponzi scheme is just the latest example of the catastrophes that can result when those economic wheels turn too smoothly, according to Stanford Business School Professor Roderick M. Kramer.

Kramer, the William R. Kimball Professor of Organizational Behavior, is a social psychologist who has been studying trust for more than 20 years. He drew on his own and others' research for an article in the June 2009 issue of Harvard Business Review on why people trust, why trust can get us into trouble, and what we can do to protect ourselves.

"What surprised me was the level of abuse of trust throughout the financial industries: its magnitude, its pervasiveness, and its duration," Kramer said.

Trust tends to be cyclical: When oversight systems seem to be working, people become less vigilant. "We don't want to spend a lot of money to catch what we think are rare incidents of abuse," he said. Then a crisis occurs, and "suddenly there's an outcry and people are willing to pay more and be more vigilant. Complacency is one of the dynamics that perpetuates periodic trust failures."

When people are too trusting, they can become victims. But people who are too distrusting may cut themselves off from beneficial relationships, Kramer said. "It's a really tricky thing to get right."

"Tempered trust," he suggests, is a way to continue trusting -- but with prudent checks that could stop the next Madoff-like scheme.

Humans are born trusting -- we have to be, since we are completely dependent on caregivers early in life.

"In many ways, trust is our default position," Kramer wrote. "The tendency to trust made sense in our evolutionary history." But while trust has helped humans survive as a species, individuals often make mistakes about whom to trust.

One reason is what psychologists call "confirmation bias." We give more weight to evidence that supports what we already think and ignore information that contradicts it. Also, people's judgments about whom to trust are influenced by subconscious stereotypes about other people's trustworthiness, which can cause us to trust even when we shouldn't.

Even if people understand that it's possible to be duped, they don't believe it will happen to them. When he has taught negotiation and power to MBAs, Kramer writes, 77% of his students estimate that they are in the top 25% of their class in their ability to judge how trustworthy and honest other people are.

More generally, people tend to underestimate the chances of something bad happening to them and overestimate the chances of something good happening.

Mistaken judgments can extend to third parties who "lull people into a false sense of security." Kramer cites Madoff's cultivation of victims from the tight-knit Orthodox Jewish community. "At the GSB," he adds, "students are taught how great networks are, but they should realize networks can be webs that ensnare people too."

Kramer identifies seven steps people can take to trust more prudently.

  1. Know yourself. Some people are overly trusting; others tend to assume the worst about others. Figure out which category you fall into so you know what to work on.
  2. Start small. "Trust entails risk. There's no way to avoid that," Kramer wrote. But you'll minimize the risk if you begin a relationship by taking small risks. This lets you assess the other person's trustworthiness while sending signals that you are interested in a mutually trusting relationship.
  3. Write an escape clause. If both you and the other party know that you have a backup plan, you'll be able to engage with more commitment, knowing that the system is set up to withstand "the occasional, unavoidable mistakes that permeate any complex organization or social system."
  4. Send strong signals. If others see that you are diligent, it will deter potential predators, who are looking for easy victims.
  5. Recognize the other person's dilemma. To build trust, you have to put yourself in the other party's shoes and reassure him that you are trustworthy. "A lot of leaders don't realize that they should be doing more to communicate the importance of trust and the fact that they are trustworthy themselves," Kramer said.
  6. Look at roles as well as people. "Deep trust in a role … can be a substitute for personal experience with an individual," Kramer wrote. We trust engineers, for example, because of their training.
  7. Remain vigilant and always question. Many of Madoff's victims did their due diligence before investing their money with him initially. "But once they'd made their decision, their attention turned elsewhere," Kramer wrote. Questioning people we have already decided to trust is uncomfortable but essential in cases where the stakes are high.

If everyone practiced this "tempered trust," would the species still gain the benefits of trust while individuals would be more protected? Kramer thinks so: "Tempered trust increases the chances we will reap the benefits of trust when interacting with trustworthy people and minimizes the damage from violated or abused trust when we happen to be dealing with someone who is untrustworthy. This principle holds for both individual-level and collective-level transactions."

Thanks to Margaret Steen / Stanford Graduate School of Business


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