May 2014

The Actuary, There and Back Again

By Thomas L. Totten

Tom Trotten

Chapter One

My career as an actuary started as many others did, with a degree in Math and for some odd reason, deciding to get my masters in Actuarial Science. The only whiff of business training occurred in my senior year as I was attempting to load up with an easy class. My accounting roommate told me to take Accounting 101 from Easy A Abraham; that class was full. So, I ended up with another professor. Unfortunately, this professor required that homework be submitted, which created a significant obstacle for me. Even so, I finished the class with a new appreciation for balancing each side of the financial statement and, when they didn’t balance, creating a new account called “un-reconciled account” or some such flippant name. This didn’t endear me to the professor and ended my academic business training.

After 20 years of pension/health consulting and running an actuarial firm, I decided to pursue an advanced degree in business to enhance my business skills and ultimately start another business venture. In my Google search for the perfect program, I saw many MBA programs which promised me riches and fame, but one struck me immediately and that was Oklahoma State’s Executive PhD program. This program was just starting, and I was eligible to apply to be in the first cohort. The biggest difference in the program (the first in the country) was the ability to receive a PhD, versus an MBA or DBA (Doctorate in Business Administration). The rub was that I would have to do original research and complete a dissertation. I had already decided on a dissertation topic and this topic would be the fuel for the new business. The program must have forgotten to check my academic credentials, because they accepted me without regard to my prior accounting grades!

There are many stories from this academic program including sitting next to Troyal Brooks (code named Garth), who considered the program. I hope to share some insightful ideas that came out of the program which are very practical and that you can immediately put to use in an entrepreneurial fashion within your own firm. While we read many journal articles of an academic nature, the best part involved working with world class professors and a cohort consisting of 18 students. These included a major airlines COO, two bank presidents, a number of entrepreneurs who cashed out of businesses and a knuckleheaded actuary (me) who did a lot of listening. I was very surprised at how academia can help in all parts of business, especially if you apply the mantra of “evidence based” decision making. That is for another day.

The first semester, we had three classes; this article will only focus on a small piece of one of them. The class was a marketing class and it was presented in a macro fashion. The most important item I received from this class was an introduction to behavioral economist named Dan Ariely. If you have not read his book “Predictably Irrational” which describes how we make financial decisions, you must. I was floored by our ability (even those of us who think we are financially savvy) to make very bad decisions. What was just as startling, however, was that the more confident or savvy we are, the higher the likelihood we will make a poor decision. This is sometimes known as the “overconfidence effect.”

The book starts out with an experiment from which we can all learn and which we can ultimately apply to our businesses in some form. You can read an excerpt at this link. The summary of the experiment involves buying a subscription to the Economist and how we make choices. You have the following options:

  1. $59 a year for the Internet subscription;
  2. $125 a year for the paper subscription; and
  3. $125 for both the paper and the Internet.

Which do you choose?
Dan tested this on very bright students at Ivy League schools and found that the vast majority would take option #3 (somewhere around 80 percent). Obviously, most people would not take option #2. While this may or may not be surprising here is what is surprising. Suppose we did not give option #3, and only gave options 1 or 2 only? What would the results be?

As you might guess, the experiment showed a high majority choosing option 1. The point to understand is that by introducing a third option, the Economist created a situation that changed the sales of the magazines. Whether the Economist knew that was the effect or not, it does show a bias in how we may not be rational decision makers, an idea upon which most classical economic theory is based.

Throughout his book, he shows other biases we make in our financial decisions which are not rational. One of my favorites is the “anchoring phenomenon,” where we have no idea of what pricing really means. However, when we hear a number associated with a price, we anchor to the number. My advice, read the chapter in the book or watch this TED talk by Dan.

Utilizing these concepts of behavioral finance, can we apply them to our businesses? I don’t recommend you attempt this at home without supervision, but I did try this in my pricing paradigms for certain services. The jury is still out on whether it succeeds in actuarial pricing. However, there can be no question about the way I perceive others try to similarly influence my purchasing decisions. I fooled the Economist by buying the print only version. Take that, Economist!