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Friday, April 9, 2010

The Upside of Irrationality

The discoveries by Duke’s Dan Ariely on how investors make decisions may transform your wealth management practice

4/1/2010

"We are all far less rational in our decision-making than standard economic theory assumes. Our irrational behaviors are neither random nor senseless: they are systematic and predictable. We all make the same types of mistakes over and over, because of the basic wiring of our brains."

That’s the financial world as Dan Ariely sees it. A professor of psychology and behavioral economics at Duke University, Dr. Ariely has wondered for years why people often don’t act in their own best interest. In 2008 he wrote about his research in Predictably Irrational: The Hidden Forces That Shape Our Decisions, which he updated last year with observations on the financial crisis. …

Other People’s Money Ariely disagrees with the assumption that people who deal with large amounts of money usually make more rational decisions about it. From investment bankers to mortgage brokers, he says, "a big part of the cause of the financial meltdown was conflict of interest."

While Ariely believes that most people are honest, he says that bad things can happen when you place good people into conflict-of-interest situations. "Imagine that I gave you $10 million a year if you were able to view mortgage-backed securities as a good product," he suggests. "Wouldn’t you be able to see them as better than they are? Of course you would."

What’s more, he adds, "when things like complex financial instruments are difficult to evaluate, it’s easier for us to rationalize unethical behavior and the effects of conflicts of interest become larger. Finally, when other people around us behave similarly, conflicts of interest rule even more." … Ariely concludes, "I think it’s inhumane to put people in strong conflict-of-interest situations and expect them to behave well."

… Interestingly, Ariely’s research finds that cheating is a lot more prevalent when it’s a step removed from cash. In Predictably Irrational, he recounts an experiment in which he first placed six cans of Coke in a refrigerator accessible to college students. All six cans were soon pilfered. He then placed six $1 bills on a plate in the same refrigerator. By the time he ended the experiment 72 hours later, none of the cash had been taken.

Ariely concludes, "When we deal with cash, we are primed to think about our actions as if we had just signed an honor code." … "When cash is taken away—and that’s what’s happening to our economic system," Ariely warns, "we will cheat by a factor bigger than we could ever imagine." Talk about a wake-up call.

Escaping Conflict-of-Interest Risks "This is a very hard time to have trust in financial advisors," Ariely says. He elaborates, "There are two kinds of trust: one is real trust, and the other is sticking a camera on someone to make sure they don’t behave badly." Today, we often opt for surveillance rather than trust. …

"Real trust is wonderful," Ariely says. But after this financial crisis, he feels that the time-consuming process of regaining it has to begin with a high degree of transparency. Unfortunately, Ariely told me, our government, legislators, and banks don’t seem to recognize what it will take to regain people’s confidence and trust. He keeps hoping some bank will break away from the herd to eliminate conflicts of interest and model full transparency—not just because it’s the moral thing to do, but because they understand that engendering trust is the best way to solve the liquidity problem. Without such bold actions, he fears we will not escape "this economic mess."

… Moving to fee-only compensation helps reduce conflict-of-interest perceptions, Ariely says, but it doesn’t solve everything. "Even with fee-only, they only get to keep the fee if they keep the client, so even if they really think at the moment that they’re doing the right thing, they’re biased to make the client happy." …

‘Hot States’ and Risk Tolerance In these turbulent times, investing in the stock market is not for the faint of heart. "The real issue for advisors is to protect people against themselves," Ariely says. He believes advisors can do more to help their clients truly understand how a loss would impact their life. "Imagine you come to me as your financial advisor," he suggests. "I ask how much are you willing to lose, and you say 20%. A little later I call you and say, ‘You lost 20%; do you want to change your risk tolerance?’"

Perceptions of any kind of risk can change dramatically when people go from a cold state, where they tend to make sound and rational decisions, to an emotional, hot state where they’re more likely to behave impulsively and irrationally. …

Ariely agrees with me that risk tolerance should be calibrated for a client’s cold state, while taking their hot (more emotional and risk-averse) state into account. In one experiment, he asked male college students whether they would engage in unsafe, kinky, or morally questionable sexual behavior. Most of the men responded negatively. Before questioning them again, he showed them erotic pictures. Thus aroused, the men were about twice as likely to say they would have unsafe sex or try to get an attractive woman drunk to seduce her. In short, they themselves failed to predict how they would feel when aroused. Other passions—rage, hunger, jealousy—may similarly make us strangers to ourselves….

Procrastination and Self-Control When emotions grab hold of us, we view the world from a different perspective. In a cold state, as Ariely calls it, we promise to save money, exercise, diet, and so on. But when we are in a hot state or aroused in some way, we feel that we have to have that new car, designer shoes, e-reader, etc. To help people start saving more money, Ariely came up with a creative idea: a "self-control" credit card that allows users to restrict their own spending behavior. Cardholders would set spending limits for clothes, entertainment, food, whatever. …

When Ariely presented this innovative concept to one of the major banks a few years ago, its executives could relate to everything he said about the terrible human costs of impulsive overspending. But when he went on to describe his idea, they seemed dumbfounded. Ariely argued that if one bank had the courage to offer consumers a card that helped them control debt and accumulate retirement savings, people would cut up their other cards and flock to this bank.

Despite the bankers’ promise to follow up on the idea, nothing ever happened. Ariely wonders if this was due to procrastination or to a conflict of interest: i.e., the potential loss of up to $17 billion in interest charges. …

Ariely comes back to the problem of not saving enough for retirement in Predictably Irrational. He blames "good old procrastination," as well as people’s inability to understand "the real cost of not saving as well as the benefits of saving." Along with the self-control credit card, he favors the Save More Tomorrow plan devised by Richard Thaler and Shlomo Benartzi. In the plan’s first implementation, a company’s new employees were asked to commit in advance to investing a portion of future raises in retirement savings. Since promising to change one’s behavior in the future is relatively painless, 78% of those eligible took part, increasing their average savings rate from 3.5% to 11.6% over the following 28 months. Ariely calls ideas like these "free lunches" that benefit all the parties involved.

Creating Loyalty: Money vs. Mutual Aid Another aspect of our predictable irrationality around money relates to loyalty toward others. In a purely social environment, people often make generous and altruistic choices. But the moment money is introduced, we lose our altruistic impulses and want to get the best possible deal for ourselves. This can become a problem for a business that insists it cares about its customers and/or employees. … A company can’t have it both ways, Ariely says. "If you want a social relationship, go for it, but remember that you have to maintain it under all circumstances."…

… Ariely points out in Predictably Irrational, money is an expensive way to motivate people. … "In a market where employees’ loyalty to their employers is often wilting, social norms are one of the best ways to make workers loyal, as well as motivated," he argues. Treating employees like "family" or members of a team tends to make them more "passionate, hard-working, flexible, and concerned." However, companies that model a social exchange must remember that they can’t expect employees to take on more work, put in longer hours, and travel at the drop of a hat without providing loyalty in return. This means helping them when they’re sick and keeping them employed when a market slump threatens their jobs. …

The Paradox of Big Paychecks After experimenting with different levels of salary and job performance, Ariely concludes that financial rewards can be a double-edged sword: "They motivate people to work well, but when these financial rewards get very large they can become counterproductive and actually hurt performance." When people start making tremendously high compensation, he explains, they are driven by the amount of the bonus, the stress involved in attaining it, and the fear of not getting it, instead of doing the best job they can. …

Asking the Right Question Sometimes we’re so intent on acting rationally that we don’t realize we’ve veered off into irrationality. For example, Ariely points out that during the mortgage market bubble, home buyers accepted that the key question was "How much house can I afford?" Many who believed the answer (and borrowed the maximum) have ended up defaulting. No one asked the right question: "Given our financial situation, how much should we spend on a house?" or its corollary: "How much should we borrow on a 30-year mortgage?"

Ariely says this is a lesson in human decision-making. When we can’t determine the right answer to the question facing us, we often figure out the answer to a slightly different question and apply this to the original problem. …

Why Can’t We Plan Better? "Rational economics is useful, but it offers just one type of input into our understanding of human behavior," Ariely writes in Predictably Irrational. "Relying on it alone is unlikely to help us maximize our long-term welfare." He cites several ways our emotions can hinder us from doing what’s in our best interest:

1. Relativity Error.

We often think we’re making enough money until we hear of someone in a similar job who earns more. …The only cure for this vicious cycle of "the more we have, the more we want," Ariely says, is to stop comparing oneself to others. …

2. The "Free" Fancy. Ariely’s research shows that once something is offered for free, people will stampede to get it, even if it winds up costing them money at a later date. …

3. Ownership Bias.

Simply put, we think what we own is worth more than it really is. Ariely finds that decisions to sell something (a car, a house) and buy a replacement are influenced by three human quirks: we fall in love with what we already have, focus on what we may lose instead of what we may gain, and assume other people will see things from our perspective. He counsels himself (and us) to "try to view all transactions (particularly large ones) as if I were a non-owner, putting some distance between myself and the item of interest." …

4. The "Price Equals Value" Perception. Ariely phrases this as "why a 50-cent aspirin can do what a penny aspirin can’t." …If you’ve been afraid to raise your rates even a little, you might try testing this irrational belief that more expensive goods and services are better.

5. The Planning Fallacy.

… Ariely adds that we often can’t plan well because we underestimate how long it will take to complete a task. This trips us up in deciding what we can and can’t afford, and what we should and shouldn’t buy. As a result, many of us don’t have a cushion when the unexpected happens.

Using Predictable Irrationality for Good As predictably irrational beings, Ariely says, "we are pawns in a game whose forces we largely fail to comprehend." We think of ourselves as sitting in the driver’s seat, but in reality our decisions are limited by the tools nature has given us. …

On a personal level, it’s good to be vigilant about a tendency to act emotionally. "Trust your intuition only after you have evidence that it’s useful," Ariely counsels. "Intuition is based on emotions, which are all about the short term; investment decisions are not."

… Ariely suggests that when you’re facing a hiring decision or deciding who to date, try testing your intuition by doing the opposite and seeing if it works out. Otherwise, you’ll never know whether or not your instinct is right. Don’t be discouraged by mistakes; they’re very educational. …

He also advises combining "immediate, powerful, and positive reinforcements with the not-so-pleasant steps we have to take toward our long-term objectives." An example might be watching a favorite TV show while exercising on a treadmill.

On a larger scale, businesses and policymakers could develop products and procedures that help us overcome our inability to act in our best interests, so we can make better decisions and improve our lives. In Predictably Irrational, Ariely quotes a Duke University colleague, Ralph Keeney, as saying that "our inability to make smart choices and overcome our own self-destructive behaviors" leads nearly half of us to early graves.

But we are not helpless. Ariely, who is already at work on a new book titled The Upside of Irrationality, urges us to "learn to embrace the Homer Simpson within us, with all our flaws and inabilities." By taking our predictable irrationality into account when we design schools, health plans, and other strategies, tools, and systems, we can create a better world. "This," he says, "is the real promise of behavioral economics."

SIDEBARS Stuck in the Status Quo? Why Women Should Take the Wheel Ariely on Retirement Planning The Risk of Parental Lassez-Faire Professor Ariely's Insights: In Brief


Olivia Mellan

, a speaker, coach, and business consultant, is the author with Sherry Christie of The Client Connection: How Advisors Can Build Bridges That Last, available through the Investment Advisor Bookstore at www.invest-store.com/investmentadvisor. She also offers money psychology teleclasses for financial advisors and for the general public. E-mail Olivia at moneyharmony@cs.com.