A Dozen Lessons about Investing and Money from Dan Ariely

Dan is a Professor of Psychology and Behavioral Economics at Duke University and the founder of the Center for Advanced Hindsight. His research and work is about how people actually act in the marketplace, as opposed to how they should or would perform if they were completely rational. His books include Predictably Irrational, The Upside of Irrationality, The Honest Truth about Dishonesty, and Payoff. His next book is entitled: Dollars and Sense: How We Misthink Money and How to Spend Smarter and will arrive in stores in November.

“We’re such good storytellers that we come up with stories that portray us in good ways, so we don’t always even see our own mistakes. And then on top of that, it’s about our social standing, and admitting failure also admits that we might be wrong in the future.” “We all want explanations for why we behave as we do and for the ways the world around us functions. Even when our feeble explanations have little to do with reality. We’re storytelling creatures by nature, and we tell ourselves story after story until we come up with an explanation that we like and that sounds reasonable enough to believe. And when the story portrays us in a more glowing and positive light, so much the better.”

A New York Times reviewer of Airely’s book Predictably Irrational describes one of his foundational conclusions as follows: “We aren’t cool calculators of self-interest who sometimes go crazy; we’re crazies who are, under special circumstances, sometimes rational.” The situations in which human are not rational are sufficiently predictable that systems can be created to achieve Airely’s goal of: “gaining a better understanding of our ability to make decisions, and identifying the places where we fall short, in order to better design products, interventions and policies.” In short, by understanding biases that can impact human behavior we can become better choice “architects.” For example, by creating the right structure we can make decisions more or less likely to happen depending on the results we want to achieve. Here is a grim but powerful example of how making something harder changes behavior:

Prior to the 1950s, domestic gas in the United Kingdom was derived from coal and contained about 10-20% carbon monoxide (CO). Poisoning by gas inhalation was the leading means of suicide in the UK. In 1958, natural gas, virtually free of carbon monoxide, was introduced into the UK. By 1971, 69% of gas used was natural gas. Over time, as the carbon monoxide in gas decreased, suicides also decreased. Suicides by carbon monoxide decreased dramatically, while suicides by other methods increased a small amount, resulting in a net decrease in overall suicides, particularly among females.

If this change can reduce the level of suicide imagine how much it can increase the willingness of people to sign up for a savings programs or a 401(k). Decision-making frictions can have positive or negative impact depending on the desired outcome. people can be nudged just like frames.

We look at the most recent evidence, take it too seriously, and expect that things will continue in that way.” “If you think about the creation of asset bubbles, that’s always what happens. Things go up and up and up, and we start thinking it has to always go up.” “It’s very hard for us to deal with lots and lots of information. Of course, today we’re getting lots and lots of information, so what do we do when we get too much information? We simplify. We use heuristics. We rely on only part of the information. On the most salient information. And that, of course, means that the most salient information is probably the information everybody else knows, as well; so we become less independent in our opinions from other investors. If everybody is in information overload, and we all do simplifications, then what happens is that we follow the simplest source of information, which is probably common to everybody.” Recency bias and herding.

A human brain has many taxing decisions to make all day long. It naturally look for shortcuts and was to reduce cognitive load. It has a preference for readily accessible information like recent memory, over the hard work of thinking and analysis. If you have seen something recently is is easier to remember and take into account. People who have seen a stock or a market index go up recently are more likely o think it will go up more. People who have seen a picture of some who has won the lottery and more likely to believe that they will win the lottery. Nothing sells more lottery tickets than pictures in the news showing ordinary person holding a cardboard check from the lottery board. The tendency of people to follow the crowd is illustrated by a story that Warren Buffett likes to tell about a deceased oil prospector who is told by St Peter that Heaven’s allocation for his profession is full. The speculator yells “Oil discovered in Hell.” A stampede of people streams out of Heaven toward Hell. St Peter informs the prospector that he is welcome pass through and enter heaven. “No thanks,” said the prospector. “I’m going to check out that oil discovered in Hell rumor. Maybe there is some truth in it after all.”

“Money is really about opportunity cost. Every time you buy coffee, the money comes from something else. What is this something else? We don’t envision it. With money, the trade offs are really unclear.” “Every time we buy something, it’s about what we are not going to be able to do in the future.” “The problem with opportunity cost is that opportunity cost is divided among many, many things.” Opportunity cost.

Charlie Munger is a strong believer in making decisions based on opportunity cost.

“In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost.” “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.” “Warren is scanning the world trying to get his opportunity cost as high as he can so that his individual decisions are better.”

When some asked you to buy something your decisions should not be limited to that question. The better question to ask is: Of all of the things I can buy or otherwise do with this money, is this what I want to do? The question should not be: should I buy stock X. Instead, out of all the stocks or other investments in the world other should I buy X?

“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.” “The overall market for annuities is bad because it is very obscure. It is hard to price. And annuity companies can use lots of hidden fees and costs. If you think about it, it’s a market where most people who sell annuities get their commissions upfront which tells you that it’s probably (a) a hard thing to sell, but (b) that the companies need to incentivize sales people to sell them, which I think suggests (c) that there has to be something quirky about the whole system.” Incentive caused bias.

Charlie Munger says: “Where you have complexity, by nature you can have fraud and mistakes. You’ll have more of that than in a company that shovels sand from a river and sells it.” As an example, Munger says the U.S. healthcare system is “ridiculous” in its complexity. “The whole system is cockamamie,” he has said. There is he value in keeping an investment plan and investment decisions simple. You will make fewer mistakes and be a happier person. Research Affiliates makes three key points about this bias:

A preference for complexity is almost hardwired into investors, their agents, and asset managers because the intuition is that a complicated investment landscape requires a complex solution; a complex strategy also supports a higher fee from both agents and managers.
Research shows that simple, low-turnover and complex, high-turnover strategies perform similarly on a before-fee basis, suggesting the former may have the advantage after tax.
Simplicity leads to better investor outcomes not because simplicity in and of itself produces better investment returns, but because a simple strategy encourages investors to own their decisions and to less frequently overreact to short-term noise.

Munger makes the point with a fishing story: “I think the reason why we got into such idiocy in investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, ‘My God, they’re purple and green. Do fish really take these lures?’ And he said, “Mister, I don’t sell to fish.’”

“A man’s satisfaction with his salary depends on (are you ready for this?) whether he makes more than his wife’s sister’s husband. Why the wife’s sister’s husband? Because (and I have a feeling that Mencken’s wife kept him fully informed of her sister’s husband’s salary) this is a comparison that is salient and readily available.” Availability bias

An idea or a fact should not be taken more into consideration I making a decision merely because it is easily available to you. Shark attack or a plane crash is not more likely because it is vivid. You are not more likely to win the lotto because you saw a winner on TV. A story bout X that you have read recently will tend to impact your decisions more than one you read years ago. Overcoming a dysfunctional heuristic like availability bias is a trained response.

“Why does cash feel so different? The agony of parting with our money has to do with the saliency of, do we see this money going away? And it has to do with the timing of whether the money is going away at the same time we’re consuming.” “For example, we find that if you have a coin flip that you have a 50% chance of making $1,100 and a 50% chance of losing $1,000. The expected value is positive, but we don’t think of it as positive. We think, “Oh, my goodness. If I lost $1,000, I would be very miserable. If I won $1,100 I would be happy, but it wouldn’t offset it, so let me not take that bet.” Now, we think that the reason is evolutionary. If you think about nature, if you get something good (like you get to eat more food and so on) that’s a good thing, but if you do something bad, you can die. So nature has kind of tuned us to look at the negative side because if you get a bit more food, a bit more money or whatever, there’s a positive expected value but it’s limited. Whereas on the negative side, you can lose a lot. So because of that we just attune more to losses.” Loss aversion.

Michael Mauboussin writes: “One of prospect theory’s most important contributions to finance is loss aversion, the idea that for most people, losses loom larger than corresponding gains. The empirical evidence suggests we feel losses about two to two-and-a-half times more than we feel gains. Loss aversion is a clear-cut deviation from expected utility theory.” Charlie Munger puts it this way: “People are really crazy about minor decrements down. Huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.”

7.”There are wealthy gentlemen in England who drive four-horse passenger coaches 20 or 30 miles in the summer because the privilege costs them considerable money, but if they were offered wages for the service, that would turn it into work, and then they would resign.” [Quoting Mark Twain] Anchoring

Anchoring is a tendency of people to grab on to inputs just because they are available. James Montier describes the bias as follows: “In the absence of any solid information, past prices are likely to act as anchors for today’s prices. For example, financial analysts often fail to revise their estimates since they get anchored to prior numbers. (they revise too late to be useful). Experiments have shown that if you ask a professional to work in behalf of the poor for free you get a much better response than if you ask them to work at a reduced rate. Free work on behalf of the less fortunate activates their desire to contribute to a community. Partial payments tend to activate anchoring which make them unhappy since they feel they have incurred a loss.

8. “People are always willing to take money from their future self, but then that puts the future in danger. So we have to work on getting people to think about how much they are really spending and also how they can invest in the future. That will take more of an effort as technology makes spending money easier to do.” “If you think about an environment in which we have to think long-term and abstractly, that’s just not something we’re good at. Saving is about now versus later, it’s about concrete versus abstract, and we don’t do those well.” Present biased preference.

A time preference can be quantified as the amount of money required to compensate the consumer for foregoing current consumption. For example,

9. “Retirement is especially difficult because we not only don’t know exactly what we’re giving up, it’s also far away in the future. That makes it very, very difficult to think about. It’s called hyperbolic discounting — we just care less dramatically about the future so not only is it hard for us to understand what we are giving up, it’s also really, really delayed.” “If you think about the opportunity cost of money — if I spend a thousand dollars now on a new bicycle I know what I’m getting. If I put it into my retirement account I don’t really know what I’ll get in the future.” Hyperbolic discounting.

Companies like Starbucks know that people will pay several dollars for a coffee house experience even though on an annualized basis it eats up a big share of their after-tax income. People like benefits that are available NOW—which is why they tend to not save for retirement and eat too many calories. The investor too often says: “To heck with the 401(k), let’s buy a waterski boat with a disco ball.”

10. “If it’s more difficult to get credit, it might make people feel more pain of paying and therefore spend less.” “I think one of the bigger problems today is how easy it is to spend money. I see a lot of younger people who get way out of whack with the reality of money because tech enables it. You order food from your phone because it is easy and someone else is doing the work of making it, but that also adds up over time. That may not be great for your finances long term because you stop thinking about how much money you’re spending each day. That feeds into all sorts of investment decisions over time.” Loss Aversion.

In my blog post on Richard Thaler I wrote:

“Hundreds of studies confirm that human forecasts are flawed and biased. Human decision making is not so great either. Again to take just one example, consider what is called the ‘status quo bias,’ a fancy name for inertia. For a host of reasons, which we shall explore, people have a strong tendency to go along with the status quo or default option.” Sales and marketing departments love status quo bias. For example, magazines often offer free trials or issues at a reduced price if the customer agrees that the business can continue to send them issues until they actively end the subscription. When making decisions people tend to follow the adage: “when in doubt, do nothing.” For this reason, getting a customer’s credit card information is a holy grail for marketers, who hate it when credit cards expire. Customers know this to some degree, which means they are reticent to hand out their credit card data even for a free trial. The incentives must be significant to obtain customer credit card data as a result.

“Buffett gave unsigned checks for $10,000 to his children, promising to sign them if he was over target weight by a certain date. Many people use commitment devices to try to keep their weight down, but Buffett’s idea had a big flaw: his children, spotting a rare opportunity to get money from the notoriously frugal billionaire, resorted to sabotage. Doughnuts, pizza, and fried food mysteriously appeared whenever Buffett was home. In the end the incentives worked: even with his children’s sabotage, the Oracle kept his weight down, and his checks went unsigned. But had he been purely rational, no commitment device would have been needed.” Nudging.

It is possible to use a bias that is dysfunctional for positive purposes as Buffett has done here. Most certainly. Charlie Munger has said: “The system of Alcoholics Anonymous: a 50% no-drinking rate outcome when everything else fails? It’s a very clever system that uses four or five psychological systems at once toward, I might say, a very good end.” Richard Thaler tells this story to talk about why people need help:

I was having a dinner party for fellow economics grad students. Before dinner I served some cashew nuts along with cocktails, and everyone kept eating them. Soon their appetites were in danger, not to mention their waistlines. I grabbed the bowl and hid it in the kitchen. People were (a) happy, and (b) they realized their reaction conflicted with traditional economic theory. Econs are better off with more choices. We humans actually need help controlling our impulses—nudges.

“Our irrational behaviors are neither random nor senseless- they are systematic and predictable. We all make the same types of mistakes over and over.” “One of the most underused interfaces in human decision-making is the calendar. If you think about it, the calendar does many, many things wrong. But one of the interesting things about the calendar is that when you have something there that is set there’s a good chance that you will actually go ahead and do it.” “I want to know if we can start building ways of preventing risks. Can reminders really help people? We all know that you get a lower price on auto insurance if insurers think you are less likely to speed. What if we started sending reminders to people about speed or remind them of some of the long-term consequences that could result from speeding?”

Another example of a dysfunctional bias involves what a New York Tines reviewer of Predictably Irrational pointed out that: “People aren’t just loss-averse; they are also effort-averse.” They also have status quo bias. Some countries have an opt-in system for organ donation. The direction they give is: “Please check this box if you would like to participate in the organ donation program.” Other countries have an opt-out system. This result of this choice architecture is striking.

organ

That brings this post bask to the first point above. Airley says that if you ask people why they made their organ donation choice the inevitably come up with a story that somehow justifies their decision regardless of whether it is yes or no.