Advisor Perspectives welcomes guest contributions. The views presented heredo not necessarily represent those of Advisor Perspectives. In your book you write about our potential overrelianceon making decisions in relative, rather thanabsolute, terms. Why can that lead us astray? Many valuation disciplines investors use, like buying only below a certainP/E ratio or when a discount to intrinsic value exceeds a certain amount,help keep focus on absolute rather than relative value. What else mightwork? Explain the pitfalls of “anchoring” on a particular data point or experience,to the exclusion of other inputs that might lead to better decisions. Describe some of the work you’ve done on honesty and the ratherunfortunate results. What conclusions do you draw from this? One chapter in the book is titled, “The High Price of Ownership.” Describewhat you mean by that. Tell us about any new projects you’re working on. In concluding Predictably Irrational, you write that, “Although irrationalityis commonplace, it does not necessarily mean that we are helpless.” Anyfinal words on how to be less helpless? Do you think the financial crisis has made the book more popular?
Recognizing the hidden forces that inappropriately influenceour decisions is the first step toward keeping thoseinfluences at bay, says Duke behavioral economist DanAriely. All of which, he adds, is easier said than done.
Having suffered third-degree burns over 70% of his bodyafter the explosion of a large magnesium flare used by the Israeli military, an 18-year-old Dan Ariely endured years of painful rehabilitation in which, he says, “Ifelt partially separated from society and as a consequence started to observe thevery activities that were once my daily routine as if I were an outsider.” Arielynow applies his uniquely honed observational skills to the study of how peoplemake decisions, particularly on those influences to whichwe are largely unaware. He last year assembled hisresearch findings into a highly readable and informativebook, Predictably Irrational. In the midst of a crisis set offby rampant poor decision-making, we caught up recentlywith Ariely for insight into how we might become a bit morepredictably rational.
Ariely’s book, Predictably Irrational, is available from thelink above.
It’s very hard with most decisions to come up with absolute answers, such ashow happy a particular activity will make us feel or how satisfactory the return ona specific investment will be. As a result we’ve adopted an easier method: to
come up with comparisons so we can pick one thing over another. This isn’tnecessarily bad, but what we choose to compare with – or what is offered as acomparison that we don’t even choose – can cause us to make a differentdecision than we would otherwise.
One study I discussed in the book was based on an actual ad I saw for theEconomist. There were three offers in the ad: an Internet-only subscription for$59, a print-only subscription for $125, and a combined print and Internetsubscription, also for $125. When I gave those options to students in a study,16% chose the Internet-only subscription, none took the print-only subscription,and 84% opted for the combined subscription. Sounds reasonable, right? Butwhat if I only offered them the Internet-only subscription for $59 and thecombined subscription for $125? Since I took out the option no one selected,surely they’d react the same way, wouldn’t they? In fact, they didn’t. With onlytwo options, 68% of the students chose the Internet-only option and only 32%took the combined offer. It’s not rational that in one case 84% were willing to pay$125 for the joint subscription and in the second case 32% were, but that’s whatcan happen when we make relative comparisons against the wrong things.
We do something similar when we look at what our neighbors and friends have inorder to judge how happy we are with what we have. At an extreme, it’s possibleto only care about relative value, which can cause problems. For example, malesea lions care a lot about their weight, because the heavier sea lions get all thefemales. They don’t care about being heavy, only heavier than the other malesea lions. It turns out, though, that in this struggle to be bigger than the next sealion they’re becoming so obese that they die young from heart attacks. That’s adecent analogy to what we’re seeing play out today: Many people may not havereally cared about how big their house or their TV or their refrigerator was, onlythat they were bigger than the neighbors’.
Part of it is just recognizing all the relative-comparison traps and taking care tocontrol what you use to compare. Amos Tversky and Daniel Kahneman once dida study in which they first asked people if they’d walk to another store 15 minutesaway to save $7 on a $25 pen. Most people said they’d do it. Then they asked ifthey’d walk for 15 minutes to buy the same $455 suit for $448. In that case, mostpeople said they wouldn’t. In reality, of course, $7 is $7. The only question youshould ask yourself is whether the 15 extra minutes of your time is worth theextra $7 you save. Whether the amount from which the $7 is saved is $10 or$10,000 should be irrelevant. You have to force yourself sometimes to think inthis kind of absolute way.
The market encourages all kinds of anchoring. The price at which you bought astock is very vivid in your mind, but in reality you’d be much better off ifimmediately after the purchase you forgot the price you paid. We also ascribeimportance to 52-week highs and lows, but why that? It would make as muchsense to look at the highs and lows over 70 weeks, or 40 weeks.
One danger of anchoring is that it can cause regret, which usually isn’t veryuseful in decision-making. There was an excellent study that looked at peoplewho forgot to mail in their frequent-flyer-program applications, who were far lesslikely to go ahead and join after getting back from a long trip. They missed gettingcredit for this big flight and thought if they joined now it would make them regretit. That’s analogous to not buying a stock at $30 because you originally lookedinto it at $20 and didn’t buy. Buying at $30 will make you regret even more thatyou missed it at $20, so you won’t buy it. That’s dumb if you really think it’s worth$50.
With investing, focusing on what’s already happened is generally a bad strategy.The decision at any point should be only about looking forward. Just adjustinghow you set up your spreadsheets and what you track on reports could help inthis regard.
We set up a study in which we had students answer 50 multiple-choicequestions. In the first case, they used a worksheet for their answers and thenwere asked to transfer the answers to a scoring sheet, called a “bubble” sheet.They handed in both the worksheet and the scoring sheet and the proctor at thefront of the room graded their answers and gave them 10 cents for each correctanswer.
In the second setup, we made one important change. This time the scoringbubble sheet had the correct answers pre-marked. So the participants, whentransferring their worksheet answers to the bubble sheet, could lie if they’dchosen the wrong answer and put the right one on the bubble sheet. They wereasked to count their right answers and write the total on the top of the scoringsheet, which they handed in along with the worksheet. The proctor then gavethem 10 cents for each correct answer based on their reported total.
In the final case we pushed the participants’ integrity to the limit. In this case theywere told to destroy both the worksheet and the bubble sheet and just takedirectly from a jar of coins at the front of the room what they had earned basedon their correct answers.
What happened? The first group, which had no opportunity to cheat, got anaverage of 32.6 of the questions right. The second group, which could cheat butmight have gotten caught because they still handed in their worksheets, claimedto have solved 36.2 questions right, on average. Interestingly, the last groupended up cheating at almost exactly the same level as the second group, eventhough there was no chance of their getting caught.
The first conclusion, unfortunately, is that when given the opportunity manyhonest people will cheat – if only a little bit – and still feel very comfortable aboutit. What was more counterintuitive was that the participants weren’t influenced bythe risk of being caught – they cheated at about the same level even when therewas no risk they’d be found out.
This to me points up the critical importance of self-interest and conflicts ofinterest. When life will be better for you if you choose a certain direction, it’s veryhard not to take that direction. I believe that’s at the center of what’s plaguing ourfinancial and healthcare systems. Imagine you go to a financial advisor or aphysician and there are two choices, A is better for you and B is better for them.What do you think they’ll recommend? If the doctor owns the equipment for a testor a procedure, they don’t have to be bad people – they just have to be people –to be influenced by that.
I don’t think you can overstate how careful we have to be about the incentives ofpeople who make decisions that affect us or who give us advice. When you seeconflicts of interest, it’s a very good indicator that something is going to go verywrong, very soon. One of the best remedies here is transparency – but it onlyhelps if people actually care about the conflicts of interest that might be exposed.
The basic idea is that ownership changes our perspective, which applies to bothmaterial things as well as points of view. One principle involved is that the morework you put into something, the more ownership you begin to feel for it. Forexample, I can say from personal experience that pride of ownership is inversely
proportional to the ease with which I’ve been able to assemble furniture. Wehave a term for that: the “Ikea effect.”Once we take ownership of an idea – whether it’s related to politics or sports orinvesting – a lot of changes take place. We probably fall in love with the ideamore than we should. We value it for more than it’s worth. And quite often, wehave trouble letting go of it because we can’t stand the idea of its loss. What areyou left with then? A rigid and unyielding ideology that can be quite detrimental toclear thought.
One interesting thing is trying to create an iPhone application to help people thinkbetter about how much money they’re spending and on what. Nothing is finishedyet, but our first idea is sort of an “alter-ego” application. If you are tempted tobuy something, you choose some trusted friend or family member from yourcontact list and then are prompted to ask yourself, “What advice would thisperson give me?” You don’t actually ask the person at this point, but the goal isto force you to think with an outside perspective. The second step is then to findout from that person what they actually would say. The first step causes you toreflect, which is important, and the second allows you to learn from others toinform longer-term decisions. We’re actually looking at lots of things that allowyou to use your cell phone as a time buffer between your intentions and youractual behavior.
There’s not one magical solution, but helping people identify the various sourcesof mistakes should make them better prepared to fight them. Emotions like angeror fear, for example, are huge drivers of mistakes. But it turns out emotions arefleeting, so one response could be to figure out how to impose a delay betweenthe time you feel something and the time you act on it. Other people are veryhelpful here – you might agree with a business partner or a friend that you haveto explain why you’re taking a certain action before you actually do it.I find forcing yourself to be a devil’s advocate, or assigning someone else to do it,can be very helpful. I also recommend to people that pre-committing to certainstrategies and then writing them down can go a long way to keeping irrationalinfluences from swaying you.None of this is easy. I think about this all the time and still find myself influencedby the wrong things too often. But the response to the book has been incredibly
gratifying – people recognize themselves in the pages and want any help theycan get in avoiding stupid decisions.
