By DYAN MACHAN
More than a quarter century after the accident, Dan Ariely, 44, a professor at Duke University, still struggles with typing. In a laboratory in Israel, where he grew up, he was standing near a magnesium flare when it exploded, inflicting burns over 70 percent of his body and leaving his right hand permanently disfigured. His long and painful recovery gave him time to observe and think about what drives human behavior from why nurses ripped off bandages in the most painful way possible, to why people tripped all over themselves when it came to investing. After that watchful waiting, he says, "I have a different way of looking at the world." He became especially interested in areas where people made repeated mistakes without seeming to learn from their experiences. It seemed so irrational.
From that experience sprang a career in which Ariely has devoted his logical mind to parsing illogical behavior, taking on a leading role in one of the investing world's most fascinating niches. Though hardly a household name, he has parlayed his research into two doctorates (one in psychology, one in business), two top-selling nonfiction books and a second career as a must-see speaker, whether he's addressing gatherings of the business elite at the World Economic Forum in Davos or entrepreneurial hipsters at Burning Man. In the process, he's become the most accessible, ubiquitous expounder of the tenets of behavioral finance, a blend of psychology and economics that seeks to explain the unexplainable why our collective hubris, fear and knee-jerk reactions keep steering the financial markets off course. "It's the most important body of work to influence our understanding of finance since modern portfolio theory," enthuses Allan Roth, a financial planner and blogger whose Colorado Springs, Colo., firm, Wealth Logic, has more than $1 billion under advisement.
In recent years interest in behavioral finance has steadily grown: It's equally valuable to retirees deciding whether to stick with their dividends or risk their savings in the currency markets, to a fund manager putting a good spin on a bad year, and to a brokerage redesigning its retirement accounts. And recently, of course, the stock market has given behavioral economists all the more to think about, as Main Street and Wall Street investors have pushed stock prices up and down in reaction to crises in Japan and the Middle East. To Ariely, when you buy a stock, "all that should count is whether you think this company will grow." But what his investing audiences value is his awareness of the constant tug of emotions. "We should be helping investors overcome emotional biases," says Mark Jamison, an executive at Capital One who has implemented ideas of Ariely's both there and in a previous job at brokerage Charles Schwab. "When more big financial institutions understand how deep these emotional issues run, they'll be all over it."
Ariely uses optical illusions and national organ donor programs to prove how fallible we can be when making decisions.
Ariely sets up experiments to examine circumstances in which we will cheat more and cheat less. It turns out that honor codes matter, and so might the sweatshirt you're wearing.
Ariely explores why and how people adapt by studying injured vets and ugly ducklings. Disproved: The hoary story of the frog that won't jump out of hot water.
2008 was a very good year for behavioral economists, too. Ariely shows why paying people huge bonuses doesn't always bring better results and can be counterproductive.
The academic clout of folks like Ariely, who's a prolific contributor to scholarly journals, has been on the rise since Princeton behavioral economist Daniel Kahneman won a Nobel Memorial Prize in 2002. (Two other Nobelists offered lavish praise for Ariely's first book, as did a slew of CEOs.) But Ariely's more notable success has come from being the guy who can talk about that research in plain English and in entertaining videos in which he'll don, say, a purple caftan or a bee costume. The question that even admirers ask is, Does his gift for reaching audiences add up to a coherent strategy for investors and consumers? (Ariely says he's more interested in making people aware of their foibles than in writing a how-to.) And a few critics contend he's too pessimistic about the capacity of people to learn from mistakes. To which Ariely responds that optimism about any aspect of human decision making, investing included, is you guessed it irrational. "From a financial perspective," he says, "you want to be the objective person in a society of overly optimistic people."
In traditional economics,markets and the people who trade in them are rational, with buyers and sellers making well-informed decisions steered by laws of supply and demand. On paper, the rules of this system work out elegantly. The problem is, the real world tends to ignore them; a century's worth of bubbles and panics have demonstrated that emotion and ignorance can always trump reason and calculation. Beginning in the 1980s, behavioral economists set out to determine whether the impact of human impulse could be measured whether people are, as the title of Ariely's first book puts it, "predictably irrational." Turns out, it could, and we are. The behavioral crowd's biggest contributions included proving the persistence of "loss aversion" showing that the desire to minimize the pain of losing money leads people to forget about losses and overrate their own successes. (Indeed, repeated studies have shown that a majority of us think we're above-average investors.) Imbued with overconfidence, investors buy hot stocks high, certain they'll go higher; they sign on with fund managers who are on a winning streak, certain that the streak is skill and not luck; and they sell stocks when they dip, the quicker to put the painful past behind them.
Behavioral economists often point out that humans aren't biologically wired to be money smart; after all, financial-management skills were not crucial to a caveman's survival. For its part, the financial-services industry has taken cues from such research to save investors from their worst caveman impulses with some success. Target-date mutual funds, which automatically spread investors' funds among stocks, bonds and other assets, were designed, in part, to keep investors from constantly moving money to chase hot performers; they've been quickly adopted by brokerages and investors alike, with $367 billion in assets to date, up 39 percent from a year ago. And more brokers and advisers are urging their clients to pen mission statements, in which they state their investment goals and then asking the clients to reread them when their emotional reactions to the headlines tempt them to make a risky move.
It's all a far cry from what Ariely thought would be his life's work back in his college days. But he got hooked on financial decision making during graduate school, he says, when he worked on a study of what economists call anchoring. Business-school students were asked to write the last two digits of their Social Security numbers as a price next to various unrelated items (books, chocolate, computer keyboards). Later, the same students were asked to bid on those items, eBay style and the ones who had higher Social Security numbers routinely bid higher. For Ariely, it was an epiphany: Consumers could anchor their decisions to prices that had nothing to do with the underlying value of what they bought. "Supply and demand are really not in play," Ariely says. "It's truly irrational."
More recently, Ariely's work has taken him where the dollar stakes are far higher, at the intersection of the financial-services industry and its customers. At a time when banks and brokers had turned free trades and checking into pillars of their marketing strategies, Ariely's research showed that free offers tended to lure customers into deals that were worse for them overall. And in 2008, just as questionable practices on Wall Street began to drag down the economy, he released a pivotal study on cheating: Most people, it turns out, are comfortable with a small amount of cheating; if the incentives are in place, they can bend the rules and still consider themselves "good people." That's one reason Ariely is disappointed but not surprised that high bonuses are back in the financial world. "If I pay people $5 million to view mortgage-backed securities as a good product, most people will believe [those securities] are good," says Ariely.
The idea that people are irrational has since become Ariely's brand and calling card. (He signs his e-mails "Irrationally yours.") In the eyes of some economists, that thesis is an overstatement. Even many behavioral-finance experts tend to think of people as rational beings who are prone to understandable errors. Investors who make unwise moves are "intelligent people who stepped on a banana," argues Meir Statman, an author and a professor of finance at Santa Clara University who has worked extensively in the behavioral field, and to call them irrational is to imply that they can't learn from those mistakes. Ariely says he sees the issue as less black-and-white: People can't train themselves to stop being irrational, but they can find ways to keep irrationality in check. That's why he's a big fan of lists, reminders and other tools for making money decisions. His corporate-consulting gigs have included work with Intuit, the creator of the financial-management software Quicken. "Some say he's a one-trick pony," says Intuit Chairman Scott Cook. "It's not true."
When we meet Ariely for coffee at a Four Seasons Hotel in Silicon Valley, he's not in his zany nonconformist mode, though he'll change into orange sneakers later that day, when he addresses a hedge-fund group. He tells us he's being besieged with angry phone calls from dentists, having asserted on NPR that tooth tenders have an incentive to give us fillings when we don't need them. But he doesn't characterize himself as a consumer-advocacy firebrand. "I don't like to annoy people," he says. "I see myself as a messenger of the data." Indeed, he's the type who can deliver criticism without too sharp a bite he can coolly eviscerate the techniques and fees of financial planners, and then give an affable keynote address to the Financial Planning Association. Ariely has handed over his own investment reins to the pros. During the crash in 2008, he found himself tempted to sell his stocks and mutual funds in a panic. Instead, he deliberately typed the wrong password into his account several times so that it temporarily blocked his access. The principle he was trying to follow: Trade on what's right for the future, rather than being swayed by an emotional moment. Months later he hired an investment adviser. "It removed the emotional burden," he says.
It didn't remove his skepticism, however. Active fund managers have not compiled a great record of late only 36 percent of large-cap U.S. mutual funds outperformed the S&P 500 in 2010, according to Morningstar. But investors are hardwired to trust authority, Ariely says, so they put up with the underperformance, along with the higher fees associated with active management. Even the 1 percent annual fee charged by many independent advisers seems out of proportion to Ariely, who feels that planners don't typically merit that kind of scratch unless they're very deeply involved in all aspects of their clients' decision making.
Here too, Ariely says, consumers are partly to blame: We're more tolerant of percentage-based fees than we are of being charged a specific dollar amount we see red, for example, when we stand at the gas station and see the number tick upward. Think how things might be different, posits Ariely, if each morning you had to write a $30 check to your investment manager: "That would make it like the gas pump, and you would feel upset." That might also make investors demand more of their planners a theme Ariely says he stressed in a recent address to a group of planners. (Richard Salmen, a past president of the Financial Planning Association, says that in some cases, a 1 percent management fee represents a discount from what an investor was paying to manage their own money; he adds that the value of a planner-client relationship is "hard to quantify.")
If Ariely ran the world, how would advisers behave? For starters, he might encourage them to approach retirement-planning with more nuance, treating it less like a race to a magic number. He says he dislikes the retirement calculators that many advisers use. "Enter five numbers and they tell you that you need to save $4.5 million," he says. "What do I do if I just get to $2 million? What sacrifices should I make for the future? How do I trade some of my quality of life for later?" He'd like to see the financial industry do more to help individuals prepare for the real consequences of their economic choices, in part by quantifying them. "If you buy a car, you are giving up 700 lattes, three vacations and some books," he says.
But as Ariely admits, such calculations seem simple to an outsider who isn't in the thick of things. (It's no accident that a research group he cofounded dubbed itself the Center for Advanced Hindsight.) He's been known to pull a gag on unsuspecting visitors, attaching a simple stick-and-string contraption to their shirt buttonholes. Unless you know the trick, it's hellishly difficult to remove. Once you do, it seems trivially easy. As Ariely says, "It's the curse of knowledge."