For behavioral economist Dan Ariely, we live in an irrational world. We often do things that go against our best interests. We sell stocks during market crashes to hedge losses. We worry about spending when we have a lot of money, and we don’t save when we don’t have enough.
Ariely, a professor at Duke University, believes that classical economics often misdiagnoses powerful social forces. For example, after studying employee engagement and how it correlates with stock market performance, Ariely launched an exchange-traded fund with Harbor Capital Advisors in February that invests in companies where employees say they feel valued. He says his research has shown that such companies are rewarded with higher share prices.
Subscribe to Newsletter
retirement
Barron’s brings you retirement planning and advice in a weekly roundup of our articles on preparing for life after work.
The 54-year-old behavioral economist, who is in the process of putting money into his ETF, has made a career of marching at his own pace. His books include Predictably Irrational: The Hidden Forces That Shape Our Decisions and The Honest Truth About Dishonesty. He signs his emails Irrationally Yours, Dan.
Ariely was born in New York City and grew up in Israel. At the age of 17 he was participating in an activity of a youth organization when a military flare exploded next to him. Seventy percent of his body was covered in burns, and Ariely spent almost three years in a hospital recovering. To this day, Ariely still has a beard on half his face because the other half is covered in scar tissue. He says the constant pain made him question everything in life. An edited version of our conversation follows.
Barron’s: How is behavioral economics different from standard economics?
Dan Ariley: Standard economics assumes that people are perfectly rational, which means people always, always, always make the right decisions. And if they don’t, it’s just because they don’t have the right information.
Behavioral economics, on the other hand, starts from nothing. Instead, we put people in different situations and see how they behave.
Are there high societal costs of assuming that people act rationally?
Enormously. If you think people are rational, then you might think that every time you see them behaving in a way that is undesirable, you will simply threaten them with a fine, and they will take that into account and act better immediately.
Take texting and driving, for example. If people were rational, imposing a fine would make people drastically cut back on their texting while driving. However, fines have no real impact on texting while driving, suggesting that the causes are not based on rational cost-benefit considerations.
Or you assume people don’t want to get diabetes; Let them eat what they want and people will do what is right. We’ve created a society where we eat too much and exercise too little, and that’s very unhealthy. And some people smoke, text, and drive, and we, as individuals and as a society, pay dearly for it in health care costs, premature deaths, and other things.
How can we stop being irrational in our financial lives?
There is no one solution because there are many forces that lead us to be irrational. So let’s think about a problem. One day you wake up, the stock market is losing money, you get stressed and you sell everything. What if we couldn’t implement things in the financial markets so quickly? Giving up control and flexibility would tame our emotions to a certain extent.
I’ll give you another example that doesn’t come from the financial markets. I don’t know if you’re aware of this, but a lot of people text while driving.
Yes.
And everyone knows that’s stupid. But the phone rings or vibrates and we become tempted and become different people. We are very curious and do something that endangers our life or the lives of others. But what if we couldn’t take our phones in the car? What if the phone had to be turned off? What if it had to be locked in the trunk? Sometimes the best way to get us to act in our long-term best interests is to ignore our short-term interests.
Are you personally better at stopping your own irrational behavior?
Yes and no. Knowing more about decision making helps with big decisions.
When it comes to the small decisions, I think the answer is no. The small decisions – get the medium coffee or the small, get the fries for lunch, get whatever it is down the aisle at the grocery store, text and drive – I’m no better.
I’ll tell you one thing I’ve done. In 2008, when financial markets were volatile, there was a weekend I was taking my wife to the mountains and it looked like it was going to be a hairy Friday for stocks. So I logged into my brokerage account with the wrong password. It locked me out and that was it. I basically prevented myself from even looking.
Why did you create an ETF to invest in companies that treat employees well?
For the past six years, I’ve collected data on how employees feel about their companies. And then I look at what that means for stock market performance. And I’m trying to understand what things companies do that employees perceive correlate with strong stock market performance and what things don’t. Salary – the absolute amount of salary – does not seem to be correlated. The perception of pay equity correlates.
Did getting burned as a teenager influence your current research?
Burning changed everything. I was in tremendous pain for a long period of time. For a long time I couldn’t do anything normal people do. And even after I was discharged from the hospital three years later, I didn’t feel like I was a part of human society. I felt so different and so isolated. And I started looking at things as an outsider.
Are you ever thankful that you’re different?
I see some of the benefits that came with my injury. I have a different perspective on life. I feel more grateful. But I don’t recommend this type of injury to anyone.
Many Americans underspend in retirement because of fears of running out of money or ending up in foster care. Why?
America’s defined contribution pension system has a built-in component of worrying about whether we’re going to have enough money. I did a study a few years ago where we asked relatively well off retirees about this and it was terribly sad to see how concerned people were. They cut their pills in half.
We compared them to teachers in Canada with defined achievements. And objectively speaking, the teacher in Canada had less savings than the wealthy Americans we studied. But because the Canadians’ performance was replenished every month, the teachers were not worried. Americans never felt like they had enough because you never know what’s going to happen. This is a real problem.
What can we do?
When we ask what to do with people who have enough money but are worried, here is one approach: A couple came to me for advice. They made a relatively good income. And the moment they retired, they felt very stressed because they had to spend money on something.
What I told them was to pick an amount they wanted to spend in a year. And I told them to transfer that amount of money to a different account every year on January 1st.
And second, I told them to send it to charity if they don’t finish it. They couldn’t really think about spending less and saving more. With this approach, the amount of money by which their accounts would shrink would be fixed. The choice is whether to spend it personally or donate it to charity. And because they’ve committed that total amount, they can make decisions that better align with their long-term spending plans.
Let’s talk about the opposite problem. Which mechanisms would help to make people better savers?
Imagine two people who both get paid on the first of the month. One has rent and long-term savings deducted from the second. And one of them will have their rent and long-term savings taken out on the 19th. What is the difference between these two people? The second person thinks they are rich for 18 days. And the person with the money that disappears at the beginning of the month would be better off because they know they don’t have any money.
We can’t take people and say, “Get sane.” What we have to do is build credit cards and savings programs and all sorts of things that accommodate our limitations and don’t let us make big mistakes.
But with credit cards, it’s more profitable for the card issuer if I overspend and list balances.
So that’s one of the general challenges. Think about who around you is genuinely interested in your long-term well-being. Maybe a spouse. On the other hand, you are surrounded by entities who all want your money, time, and attention right away. And they don’t care about your long-term well-being.
Does all of this make you optimistic or pessimistic about our future?
It makes me optimistic. If I thought that this world and the current state is as good as it could be – that this is the result of eight billion sane people – I would be very upset. But if I think it’s the result of eight billion irrational people, then there’s a lot of room for improvement. So I would say we still have a long way to go, but we can do it.
The behavioral economics perspective is sad in a sense, but optimistic. It’s sad because we’re flawed, and we’re emotional, and we’re short-sighted, vengeful, and so on. It’s optimistic because we can do much, much better.
Thank you Dan
write to [email protected]
Comments are closed.