Dan Ariely on Irrationality and What to Do with It
by Richard F. Stolz
Who:
Dan Ariely, Ph.D.
What:
Prominent behavioral finance expert, professor, author, and keynote speaker at FPA Denver 2010
What’s on his mind:
The more you “invest” in your own ideas, [the more] you fall in love with them.… There is real danger of falling prey to our own vision of the past, because there is a good chance it won’t be a good description of the future.…
One trick to avoid falling into that trap is not to have just one “story” for the past. Instead, try to have several accounts of what is happening.… If the circumstances change, it will be easier for you to update your ideas.
Podcast
Check out our podcast with Dan at www.FPAjournal.org/Home/PodcastPage.
Who says “irrational” behavior is inherently problematic or unpredictable?
Not Daniel Ariely, the James B. Duke Professor of Behavioral Economics at Duke University’s Fuqua School of Business. Ariely, an FPA Denver 2010 keynote speaker, recently published his second book on the subject, titled The Upside of Irrationality. That followed the publication of his first bestseller, Predictably Irrational, published in 2008.
“Irrationality” may be loosely defined as thoughts and behavior that defy traditional economic assumptions about self-interest, or actions and decisions taken contradictory to objective evidence of the correctness of that position. In other words, the behavior planners sometimes encounter working with clients, in the pronouncements of investment strategy gurus, and in the rulings and laws promulgated by regulators and politicians. In addition, many planners will recognize a bit of irrationality in themselves.
Whether that’s a problem or not, Ariely contends, depends on the circumstances and objectives of the people involved. The issues he explores in his research include the sources and patterns of irrational thought, with particular focus on economic behavior.
Ariely began thinking about irrational behavior when, as a young man in Israel, he was on the receiving end of the physically painful consequences of it from nurses treating his severely burned body. His thought process was abetted by a detached perspective he says he developed while cloistered in a hospital for three years. Irrationality, as his books’ titles suggest, is both predictable and has some benefits. For insights on how planners can learn to live with—and perhaps even prosper from—irrationality, the Journal recently spoke with Ariely.
What started you down the path of exploring “irrational” behavior?
It started from being in the hospital—I was badly burned when I was young and in the hospital for about three years. Hospitals give people lots of opportunities to observe irrational behavior. It changed my perspective in multiple ways. First, I had this debate with the nurses about the right way to remove bandages from burn patients. They believed that it was better to rip the bandages off quickly, because although the pain was greater, it didn’t last as long. I hated that approach when they used it on me, but they assured me that they knew what was best for me.
When I got out of the hospital, I started doing experiments with people. I learned that the nurses were wrong. At that time I had already begun to study economics, where I was told that people are supposed to make the right decisions all the time, particularly if they are good people, have the right incentives and experience. The nurses were good people with lots of experience and the right incentives, but nevertheless were getting things wrong in a systematic way—counter to economic theory. That made me start thinking more generally about other cases in life where people make the wrong decisions systematically, even though they believe they are making the right decision.
The other thing that happened in the hospital is that I got a bit separated from life. Imagine you’re in bed for a long, long time, and you don’t do anything you used to do before. It’s a completely different reality. All of a sudden I started looking at things in a very different way. It got me to feel like a little bit of an alien. That gave me a different view of the world. That has stayed with me.
Suppose a financial planner believes that a client is driven to become extremely wealthy for an irrational reason like jealousy, and this is making the client miserable. How might a planner explore with clients their sources of happiness without intruding into the realm of psychotherapy or spiritual counseling?
It comes down to exploring the role of money in people’s happiness. Money is the oxygen of life. It’s what we use to buy happiness. The question is what’s the amount of happiness you can buy with the money you have. Or what should you strive for? That’s something that, in my mind, financial planners don’t do enough of with their clients. You can think of extreme cases—someone who is obsessed with money or very jealous of someone else’s money. But think about something more ordinary—one’s house. Helping a client to figure out how much money to spend on a house is important. Today, people go to a real estate agent and the agent asks you, “How much can you afford to spend?” The real question is, what kind of house should you buy? What would make you happy? What’s the difference between having three bedrooms or four? Should you buy a second home or not? Often, financial planners think of their roles narrowly as optimizing their clients’ portfolios. But that should be the smallest part of their role. Financial planners should help people figure out how to live. What’s the role of money, and how much is needed, in terms of life quality? If planners don’t help clients think about the quality of their lives, I don’t think they can justify their fees.
To what extent do people behave differently when purchasing tangible goods versus professional services, such as financial planning?
When people acquire tangible goods, they can have a feeling or understanding of the underlying production costs, so they can form a judgment about whether the price being asked is fair. But when a consumer is paying a lot of money for a service like financial planning, it’s hard for them to decide what it’s worth. So we use other cues, heuristics, shortcuts to decide what something is worth. Part of the value of something is what somebody has invested in it—not necessarily what the thing is really worth. It can be illustrated with this not-so-good joke: Somebody goes to a mechanic with a problem with his car. The mechanic opens the hood, hits something with a hammer, and the car starts running perfectly. The mechanic says, “That will be $100.” The customer says, “You’re going to charge me $100 for hitting my car with a hammer?” The mechanic says, “No, the hammer blow costs $1. Knowing where to hit costs $99.”
Jokes aside, value is a hard thing for people to understand. We have done a study asking people how much they’d be willing to pay to recover their hard drive if they lost a little bit, a medium amount, or a lot of data from their hard drive. Then we asked them the impact if they knew the technician spent either a short amount of time, a medium amount of time, or a lot of time to fix it. People were not as sensitive to how much data they lost, as to the amount of time the technician took to restore the data. Which means people are willing to reward incompetence—if it takes one technician 24 hours to fix a problem, and another one five minutes to fix it, the slower technician is incompetent. Yet people see the person who spent 24 hours fixing their computer as investing more effort, and they’re willing to pay more for it. That’s the challenge with financial planning—many people don’t see the value and they don’t see the work, skill, and expertise that go into it.
Are there any ethical constraints on using the insights you have compiled about consumer behavior in the way a financial planner should price and sell his or her own services?
Every time you learn a skill involving human persuasion, you can use it for good or for bad. One of my students addressed this subject in a short fictional story she wrote about an Indian immigrant woman running a simple restaurant. Her daughter, a marketing executive with an MBA, gets involved, trying to help her mother, by changing the restaurant in superficial ways, changing the plate size, giving fancier names to the items on the menu, and other changes so she can raise the prices. The mother struggles with these changes, asking herself, is this still her restaurant, or not? How much of these changes are real, and how much is fake? There’s a real dilemma in behavioral economics—whether to use what you learn for good or for bad. People clearly are using it for both. The ethical dilemma is absolutely there. In almost all cases, there’s enough room for meeting a real need that you don’t need to leverage behavioral economics to create demand or raise your prices artificially. In financial planning, the current value that planners are giving is so miniscule compared to what they could be doing that I think that there is a lot of room for using behavioral economics for everyone’s benefit. If the planner understood how difficult it is for people to think about money, and if they focused on helping them to make better decisions, they could get tremendous value out of it without the need to use tricks to get people to pay them more.
In managing their practices, planners need to understand how to motivate their staff. In your research you have found that performance bonuses can backfire. Can you summarize those findings?
If I give you a very high bonus incentive, you will be very motivated and want to achieve the performance level required to get that bonus. If it’s a physical task, you can translate that motivation to performance. But if it’s a mental task, that motivation doesn’t necessarily lead to the desired performance. If I told you that if the financial plan you produce for me is your best ever, I’ll give you $100,000, and if it’s not, I’ll sue you, you’ll be very motivated—and there will be some things you would be able to do to improve the quality of the plan. You would spend more hours on the task—something you have control over. But if you needed to be more creative to earn the reward, would you be able to be? Would you be able to concentrate at a higher level? What often happens when incentives become too great is that people will be constantly thinking about whether they will be getting the bonus or not. The logic of big bonuses is the logic of distraction, to get people to think about something other than the task itself—to think mainly about the money. And this is why it can fail.
You have written that the best way to deal with procrastinators is to have them commit to a course of action, and encourage them to take advantage of mechanisms that automate the process of meeting their self-imposed deadlines. How might that work in a relationship between a financial planner and a client?
Procrastination happens a lot with big, complex decisions, like creating a will. There are two tricks financial planners can try to get people to do what they need to do. One is to be explicit about the opportunity cost of time. This requires getting the client to state how long he or she will take before making the decision or taking the action. If a time is set for the action to take place, the odds are much higher that it will actually take place. You can also be explicit about the cost of the timing. Here’s a simple example: Say you’re debating on a decision of which camera to buy. The cost of delaying the decision may be losing the opportunity each day to take pictures of your family. Or in the case of a financial decision, every day you put off buying that life insurance policy, there’s a risk you’ll die and your family won’t be adequately protected.
There’s a second approach to dealing with clients’ procrastination: getting it to work in favor of the goal. Say a client asks you how much he needs to be saving a month towards retirement. Suppose you tell the client the answer is $3,500, and the client says, “Okay, that’s good to know. I’ll figure out when I can start doing that.” Instead of letting it go at that, you can say, “Okay, let’s start deducting $3,500 a month from your paycheck now, and as you figure out the exact amount that works best for you, we can change it.” You can do the same thing with life insurance—have the client buy a reasonable amount today, and say it can be adjusted later. Procrastination is about our difficulty acting for the long term, yet financial planning is all about the long term.
You have written that people typically take ownership of their opinions, find it hard to let them go, and develop tunnel vision without realizing it. You’ve also spoken about how easy it is to fail to manage conflicts of interest without realizing it. Can these traps be avoided?
It is amazing how easy it is for us to fall in love with our own ideas. For example, advisers have their own approaches to investment. But the more you “invest” in your own ideas, the more you fall in love with them. The reality is, we should all believe more in the fine print that says, “historical performance is no indicator of future performance.” There is real danger of falling prey to our own vision of the past, because there is a good chance it won’t be a good description of the future. One trick to avoid falling into that trap is not to have just one “story” for the past. Instead, try to have several accounts of what is happening in financial markets. By acknowledging that more than one story could be correct, you then just pick the one you think is most likely, but keep reminding yourself that it’s not the only one. If the circumstances change, it will be easier for you to update your ideas.
As for conflicts of interest, they color people’s view of the world in a very, very deep way. The easiest way to think about it is sports. If you’re a fan of Team A and the referee makes a call against Team A, you think the referee is an idiot or blind. In sports, it doesn’t matter so much. But in other areas, like finance, it matters a lot. When people have conflicts of interest, they don’t see it. As a result, they are likely to do things that are not in the best interest of their clients. When I ask people in a particular profession if they ever fail to act in the best interest of their customers because of conflict of interest, they say no. But when I ask them if others in their field have this problem, they say yes. And it’s not just a question of a financial conflict of interest. It can be social, too. If a financial adviser buys me dinner, I like him a little more and I’m more likely to want to do what he says without realizing how I have been influenced.
You’ve made the point that some decisions that appear irrational from an economic perspective are quite rational from a social utility perspective. In thinking about their clients, can planners determine which perspective is most appropriate to a particular financial decision? Should they even try?
This brings up the very basic question of the meaning of “rational.” There are things about the human condition that we’d like to fix—for example, the tendency to act only in our short-term interest. That’s why we over-eat, send text messages while driving, and fail to save adequately for retirement. But there are other kinds of behaviors that are not rational from the perspective of standard economic theory that we may not want to fix. Think about human caring, giving money to charity and tips to waitresses. If you want people to be perfectly rational, they wouldn’t do these things. Why tip a waitress who you will never see again in a restaurant in a big city? It’s irrational to give money to the victims of Hurricane Katrina.
We have learned that students are less likely to give money to a charity right after leaving an economics class than those leaving some other class, because economics is about selfishly maximizing your own welfare. If everybody around you was just trying to maximize their own utility, what would be the odds that you could leave your wallet on your desk for five minutes and nobody would steal it? Very low. It’s quite amazing how much trust we actually have with financial advisers, even after Bernie Madoff. How many people actually ask to see evidence that their money is secure somewhere? It’s wonderful that we can have trust, because what would it be like to live in a society without trust? But as wonderful as caring and trust are, they do carry a cost. The cost of trust is that when people violate our trust, we get angry and vindictive.
Now if your clients are acting “irrationally,” or inconsistently with their stated goals, it boils down to two kinds of behavior. One is timing inconsistency, where you have a different desire for yourself in the long run versus the short run. The second kind is their attitude towards investment risk in the abstract, versus in a real situation. Suppose you ask a client how much he’s willing to lose on an investment, and he says 25 percent, then a week later you call him and tell him he has just lost 25 percent. Odds are that he won’t be as philosophical about losing that 25 percent as he was when he told you what kind of loss he could tolerate as an abstract concept. I encourage advisers to get their clients to write letters to themselves. Suppose I wrote a letter to myself saying, “Dear Dan: I’ve been evaluating my portfolio and its risk characteristics. I understand I might lose up to 15 percent a year, but I’m willing to do it. And if it happens, I promise not to revise my strategy because random things happen.” By having them be explicit about it, and connect the long term with the short term, this helps them to resolve the inconsistent desires.
I believe the questionnaires that many financial advisers use to gauge their clients’ risk tolerance, say on a seven-point scale, aren’t very useful because people cannot accurately tell you what their risk tolerance really is. But if clients say they have a very low risk tolerance and only put money in CDs, that might prevent them from achieving their long-term non-financial goals; you have to fix that inconsistency.
How do you apply your insights on “predictably irrational” behavior to your own financial life?
When the recent recession started, I began to rely a lot more on my financial adviser. When everything’s going well, the value of financial advisers for someone like me is not very high. But when things go down, emotions can take over, so it’s good for me to have an adviser as a sounding board.
Also, I try not to be reactive. Imagine two strategies for re-balancing your portfolio. You can look at your latest account statement and see what’s going on, then decide what to do. Or you can decide what to do without looking at where your portfolio is today—just make the transactions necessary to execute your strategy. I try to do the second. Why? Because if I just look at my portfolio to see how it has responded in a volatile market, the emotions that will be created will influence me. If I have lost money, I’ll be upset. If I have made money, I’ll be happy, and that would change my strategy—but not in the right way. If you want to be disciplined about it, you will look objectively at what’s happening in various markets and try to understand what may happen next, regardless of the price you paid for assets already in your portfolio. You want to look forward, so I try to eliminate the possibility of being reactive.
Also, when the fluctuations were extreme in 2008, as a self-control mechanism, I decided to enter the wrong password three times for accessing my portfolio online to lock myself out for a few weeks. I would still call my financial adviser from time to time to talk about what to do, but I didn’t want the ability to go in and see what was happening every day because it was so miserable. There is a principle called loss aversion, where losing is about twice as painful as gaining.
I was really miserable.
How will today’s uncertain economic environment shape your message to planners at FPA Denver 2010 in October?
In good times, financial advisers, frankly, don’t add that much value and don’t need to be that good. There are simple lessons they can impart about managing tax liabilities, balancing your portfolio—it’s not trivial, but you don’t need to be a highly intelligent, creative person. But when times are tough, and people don’t have enough money to retire, the value that a good financial planner can provide is much greater. The secret, going back to something I said before, is how does money translate to quality of life? What should clients buy? What should they not worry about? Which risks should they take, and which should they avoid? The days when you just ask people to rate their risk tolerance on a seven-point scale and build a portfolio around that are over. Now we really need to get down to what people are really trying to get out of their lives, what they can afford, what they can’t afford. What compromises should they make? What kind of sacrifices should they make now for the future? That’s a really hard question. If you sacrifice too much and die with a lot of money, you might be living a miserable life because you have exaggerated fears about the future.
I think most financial planners want to run away from these kinds of questions. I think many of them also don’t want to get involved with people who really don’t have enough money; they’d rather help wealthy people who really don’t have many problems, besides things like taxes and estate planning issues. But the real social value in financial planning, for those who are interested in that, is in helping people who don’t have enough money. In Denver, I plan to try to help attendees think about how people think about money, and how they can help clients understand the financial decisions they have to make, and how to better manage the trade-offs in life.
Richard F. Stolz is a financial writer and publishing consultant based in Rockville, Maryland.
