2009 PredictablyIrrational

• (Ariely, 2009) ⇒ Dan Ariely. (2009). “Predictably Irrational: The Hidden Forces That Shape Our Decisions - revised and expanded edition.” Harper-Collins New York. ISBN:978-0-06-135323-9

Subject Headings: Behavioral Economics.

Cited By

• http://scholar.google.com/scholar?q=%222008%22+Predictably+Irrational

2014

• http://en.wikipedia.org/wiki/Predictably_Irrational
  • Predictably Irrational: The Hidden Forces That Shape Our Decisions is a 2008 book by Dan Ariely, in which he challenges readers' assumptions about making decisions based on rational thought. Ariely explains, "My goal, by the end of this book, is to help you fundamentally rethink what makes you and the people around you tick. I hope to lead you there by presenting a wide range of scientific experiments, findings, and anecdotes that are in many cases quite amusing. Once you see how systematic certain mistakes are--how we repeat them again and again--I think you will begin to learn how to avoid some of them".

Quotes

Abstract

Why do our headaches persist after we take a one-cent aspirin but disappear when we take a fifty-cent aspirin? Why do we splurge on a lavish meal but cut coupons to save twenty-five cents on a can of soup? When it comes to making decisions in our lives, we think we're making smart, rational choices.

But are we?

In this newly revised and expanded edition of the groundbreaking New York Times bestseller, Dan Ariely refutes the common assumption that we behave in fundamentally rational ways. From drinking coffee to losing weight, from buying a car to choosing a romantic partner, we consistently overpay, underestimate, and procrastinate. Yet these misguided behaviors are neither random nor senseless. They're systematic and predictable making us predictably irrational.

Ch. 4 The Cost of Social Norms: Why We Are Happy to Do Things, but Not When We Are Paid to Do Them p75

• https://www.youtube.com/watch?v=OdjlOgGVRVA

Ch. 15 Beer and Free Lunches: What is Behavior Economics, and Where Are the Free Lunches p309

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Thoughts about the Subprime Mortgage Crisis and Its Consequences

For a long time, economists have maintained that human behavior and the functioning of our institutions are best described by the rational economic model, which basically holds that man is self-interested, calculating, and able to pefectly weigh the costs and benefits in every decision in order to optimize the outcome.

But in the wake of a number of financial crises, from the dot-com implosion of 2000 to the subprime mortgage crisis of 2008 and the financial meltdown that followed, we were rudely awakened to the reality that psychology and irrational behavior play a much larger role in the economy’s functioning than rational economists (and the rest of us) had been willing to admit.

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below are not based on experiments with the stock market itself, because the nature of the stock market makes it very hard to conduct any direct experiments. Instead, they are based on general experimental findings in psychology, economics, and behavioral economics, offered from my personal and professional perch, and they should be taken with an appropriate amount of salt.

(1) Why did people take on mortgages that they couldn’t really afford?

Politicians, economists, newscasters, and the public have placed the blame for large and risky mortgages on different parties. Some think irresponsible borrowers assumed more debt than they had reason to believe they could afford. Others think borrowers only followed the guidance of predatory lenders, who at the time were thought to be experts. It seems to me that both accounts have some truth to them, but I also think that the main culprit is the inherent difficulty of figuring out the ideal amount of mortgage someone in a particular financial situation should take on.

Here is the crux of the problem: When the housing market was hot, the bankers who gave out mortgages assumed, logically, that the customers would not want their houses to go into foreclosure. To further ensure that people would repay their loans, the mortgage contracts also included a variety of penalties and fines, in case people decided to walk out on their mortgages. On first glance this logic seemed very appealing: given all the terrible things that could happen to those unable to repay a loan (loss of their homes, wrecked credit, foreclosure fees of different sorts, legal fees, and the possibility of being used by the lender for a deficiency), the banks assumed that people would try very hard not to overborrow.

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(2) What caused bankers to lose sight of the economy?

The financial crisis of 2008 left a lot of people feeling that the investment bankers involved were fundamentally evil human beings, and that the economic crisis resulted from their deceitfulness and greed. Certainly, people like Bernard Madoff were out to cheat their investors for personal gain. But personally, I think calculated cheating was the exception rather than the rule in this financial fiasco.

I’m not suggesting in any way that the bankers were innocent bystanders, but I do think that the story of their actions is more complicated than simply accusing them of being bad apples. ...let’s take stock of what we know about conflicts of interests — a very common foible in the modern workplace. …
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I plan to take a proactive step by looking more closely at my relationships with physicians, lawyers, bankers, accountants, financial advisers, and the other professionals to whom I turn to for expert advice. I can ask doctors who prescribe me drugs whether they have any financial interest in the pharmaceutical company; financial advisers whether they get paid by the management of particular funds they are recommending; and life insurance salespeople what kind of commission they are working on — and seek to establish relationships with providers who do not have conflicts of interest (or at least get a second independent opinion).
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(3) Why didn’t we plan better for the possibility of bad times?

The general phenomenon social scientists call the planning fallacy has to do with our tendency to underestimate how long we will take to finish a task (it explains why roadwork never seems to get finished and new buildings never open on time). There is a very simple way to demonstrate the planning fallacy. Ask some undergraduate students how long it will take them to finish a big task, such as their honors thesis, under the best conditions. “Three months” is the standard reply. Next ask them how long it would take under the worst conditions. “Six months,” they routinely offer. … Given the first two answers, you might expect that they would predict that finishing their honors thesis would take them closer to six months, or maybe four and a half months, but they don’t. Their answer is always too optimistic no matter how unrealistic this may actually be. …
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Finally, I think that punitive finance practices — including high-interest credit cards, car title loans, payday loans,* and the like — that prey upon those with the fewest resources have to be controlled. It is more appropriate, fair, and better for the economy, as a whole, if we spread the cost of financial services such as checking accounts, credit cards, and insurance among all customers rather than forcing those with fewer resources and fewer options to carry a large part of the burden. At the end of the day we have to realize that when we financially squeeze people who don’t have much financial juice in them, it hurts all of us.

(4) Did the government overlook trust as an important economic asset?

In September 2008 Henry Paulson, who was then secretary of the Treasury, told American legislators and the public that unless they immediately coughed up a substantial amount of money ($700 billion) to buy toxic securities from the banks, devastation would result. When this bailout plan was proposed, it looked as if the American public really wanted to strangle the bankers who had flushed our portfolios down the toilet. (The eventual name of the bailout package was “The Troubled Asset Relief Program,” but this did little to change the sentiment on the street.)
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While it is clear that the legislators do not yet understand the importance of trust, I remain hopeful that some of the banks will decide to step away from the herd and be good guys — creating trust by eliminating conflicts of interest and modeling complete transparency. They might do it because it is the moral thing to do or, more likely, because they will understand that the best way to solve the liquidity problem is to engender trust. It will certainly take a while for them to view the world this way, but at some point they will understand that unless they create a new structure to slowly regain our trust, none of us will get out of this economic mess.

(5) What is the psychological fallout from not understanding what the #$%^ is going on in the markets?

At the end of 2008, consumers’ confidence was at its lowest since 1967 (the year that research groups began measuring it), suggesting that the economy was also in the worst shape since 1967, and feeding on itself to further sink the economy. While there is no question that the state of the economy was indeed depressing, I suspect that there were other factors — ones not related to the underlying economic situation — that contributed to our gloomy outlook. Henry Paulson’s behavior, as described above, gave us a clear message that no one really understood what was going on in the financial markets and that we had no real control over the monster we had created. …
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Maybe one day journalists, or Henry Paulson, or the next chairman of the Federal Reserve, or Barack Obama, or the new leaders of other government institutions will value our wellbeing enough to explain to us what is going on and the rationale behind the decisions that they make. And the sooner the better because I am not sure how many more shocks we can take.

(6) Can a global market increase irrational behavior?

For at least the last decade, the globalization of markets has been promoted by many as a good thing. The belief has been that a move from multiple and semi-independent markets toward one big market increases liquidity, encourages financial innovation, and allows friction-free trade. As a consequence, today, in case you haven’t noticed, there is not much difference between the Japanese, British, German, and American stock markets. We see them rise and fall almost in unison, if to varying degrees. But as we witness the effects of increased globalization, we should ask ourselves what are the benefits and the costs of having one large market. I suspect that one large market can, in fact, reduce financial innovation, be dangerous to our financial health, and ultimately fail to protect us against financial meltdowns.
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Of course, globalization would be wonderful if the result were a perfect global market. But given the degree to which human beings are prone to mistakes and irrationality, it seems that any market we create is likely to be imperfect. In the end, I would much prefer to have multiple, somewhat independent markets, each perhaps less efficient — but more isolated, flexible, nimble, competitive, and more likely to evolve over time — producing more efficient and robust financial markets.

(7) What is the right amount to pay bankers?

Recently there has been a public outcry against astronomical executive salaries. The basic public sentiment is that it seems unfair that people make so much money for mismanaging our money, especially when it is so difficult to see how bankers’ talents and abilities justify their compensation. Naturally, it’s particularly offensive when executives receive high bonuses after disastrous performances, or, worse, when the bonuses come from taxpayers’ money courtesy of government bailouts. Not surprisingly, bankers have fought back, claiming that the high salaries are required to attract the best and brightest to crucial, high-stress, high-skill positions, and that the most talented and valuable bankers would go elsewhere if salaries were capped. It is your basic free market argument: if they can’t recruit and retain the best minds in business, these minds will simply go elsewhere, leaving us with less qualified people in charge of the economy — and that, in the end, would send us all down the tube. Rather than seeing this as an ideological debate between self-serving bankers on one side and morally outraged taxpayers on the other, it is more useful to ask what we really know about the relationships between very large bonuses and job performance.
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If I were Obama’s financial czar, I would try to get the bankers, and the system that has given them a warped sense of entitlement, to turn over a new leaf by encouraging the creation of new banks with new pay structures. These new banks would promote the idea that bankers are not greedy bastards but are ethical, upstanding people who fulfill a crucial role that is central for the functioning of the economy and the country (which, in fact, they do). The “old bankers” who feel they needed millions of dollars to do their jobs, and millions more in bonuses to do their jobs well, could try to compete in this new market. But who would want to bank with them when the alternative is a new bank with a more idealistic underpinning and a more realistic, and more transparent, salary structure?

(8) Rational economics has always been the basis for setting up policies and designing our institutions. What’s wrong with that?

Neoclassical economics is built on very strong assumptions that, over time, have become “established facts.” Most famous among these are that all economic agents (consumers, companies, etc., are fully rational, and that the so-called invisible hand works to create market efficiency). To rational economists, these assumptions seem so basic, logical, and self-evident that they do not need any empirical scrutiny. Building on these basic assumptions, rational economists make recommendations regarding the ideal way to design health insurance, retirement funds, and operating principles for financial institutions. This is, of course, the source of the basic belief in the wisdom of deregulation: if people always make the right decisions, and if the “invisible hand” and market forces always lead to efficiency, shouldn’t we just let go of any regulations and allow the financial markets to operate at their full potential? On the other hand, scientists in fields ranging from chemistry to physics to psychology are trained to be suspicious of “established facts.” In these fields, assumptions and theories are tested empirically and repeatedly. …
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I realize that this is not an elegant solution because conducting rigorous experiments in public policy, in business, or even in our personal lives is not simple, nor will it provide simple answers to all of our problems. But given the complexity of life and the speed at which our world is changing, I don’t see any other way to truly learn the best ways to improve our human lot. Finally, I’ll say this: In my mind there is no question that one of the wonders of the universe is how complex, bizarre, and ever changing human behavior is. If we can learn to embrace the Homer Simpson within us, with all our flaws and inabilities, and take these into account when we design our schools, health plans, stock markets, and everything else in our environment, I am certain that we can create a much better world. This is the real promise of behavioral economics.

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References

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• (Gneezy & Rustichini, 2000) ⇒ Uri Gneezy, and Aldo Rustichini. (2000). “A Fine is a Price.” In: Journal Legal Studies, 29.
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• (Heyman & Ariely, 2004) ⇒ James Heyman, and Dan Ariely. (2004). “Effort for Payment a Tale of Two Markets.” In: Psychological Science, 15(11).
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	Author	volume	Date Value	title	type	journal	titleUrl	doi	note	year
2009 PredictablyIrrational	Dan Ariely			Predictably Irrational						2009