Economics tells us we should engage in rational decision making.  We shouldn’t take irrational risks.  Okay, then tell me why do so many successful, high-profile, and otherwise smart individuals take what appears to irrational risks that can turn their world upside down?   

Enron financial engineers, the Wall Street wizards who helped implode the financial market and deepen our recession, and of course the parade of sex scandals such as Governor Elliot Spitzer and his call girls, former presidential candidate John Edwards and a campaign consultant with a love child, Governor Mark Sanford and his Argentinean soulmate mistress, Senator John Ensign and the wife of a former top aide, and just last week – David Letterman and certain Late Night Show staffers, all demonstrate a lack of “good judgment” or rational risk taking. 

What were they thinking?  How could smart people get it so wrong?

Senator Tom Coburn, in talking about Senator John Ensign who admitted to having an affair with the wife of his close friend and former top aide, offers some interesting insight.  Coburn was recently quoted in the New York Times as saying, “John got trapped doing something really stupid and then made a lot of other mistakes afterwards.”  But my favorite line is when he said, “Judgment gets impaired by arrogance.” 

 Bingo!

Coburn’s observation dovetails with the research done by behavioral economists.  Those are the folks who look below the surface at what we do and examine how decisions are really made.  Among the interesting findings in this field is the role of overconfidence.

Overconfidence contributes to hubris and arrogance.  It causes people to take huge risks.  Their perceptions of invincibility can lead to large scale risk taking and have legal implications that trigger liabilities ranging from negligence to brazen malfeasance, such as fraud. 

Organizations seeking to effectively manage their enterprise wide legal risk need to be cognizant of this behavioral flaw and blind spot it creates.  The best way to guard against it is to properly train all employees, including the most senior AND to create a system of rational checks and balances to protect the business from poor individual judgment.   

The conflict between behavioral economics and business economics presents serious and continuous leadership challenge.