Get Rational About Irrational Money Moves
by Laura Rowley
Wednesday, December 30, 2009, 10:18AM ET - U.S. Markets close in 5 hours and 42 minutes.
Laura Rowley Money & Happiness
Posted on Wednesday, February 20, 2008, 12:00AM
Professor Dan Ariely of MIT has long been fascinated by the things that really influence our daily decisions, as opposed to what we think influences them.
At age 18, Ariely was burned over 70 percent of his body in an accident while serving in the Israeli army. He spent three years in the hospital undergoing excruciating operations. That experience turned him into a close observer of human behavior.
Dependable Irrationality
Traditional economic theory presumes people are rational, or capable of making the right decisions to maximize their own welfare. But behavioral economists like Ariely suggest that people are often irrational in their decision-making.
What's more, Ariely argues, people are predictably irrational -- their irrational behavior is neither random nor senseless, but occurs the same way, over and over. Identifying irrational patterns can help us change our behavior.
That's the premise of Ariely's new book, "Predictably Irrational: The Hidden Forces that Shape Our Decisions." In it, he examines a variety of behaviors, such as why many people procrastinate in saving for the future; why we make purchases we later regret; why we can't think clearly when we're emotionally aroused (which can happen as often in a mall as anywhere else); and why we can't stop comparing ourselves to our neighbors.
It's All Relative
For starters, it's important to recognize that the brain has a hard time assigning an abstract value to things. So it focuses on relativity instead.
Let's say you're considering adding a screened-in porch onto your home. "Should you pay $200 a square foot to get another 100 square feet or not? This is actually a very hard computation to make," says Ariely. "You're supposed to think about all the other things you can do with $20,000; how much the space will increase your quality of life, how much stress [the construction] will create on everyone."
As a result, the brain shortcuts to comparing things that are easily comparable and does a relative calculation instead. "We see a neighbor who has a screened-in porch and say, 'That's exactly what's missing from my life to become happy,'" says Ariely. "The relativity is a substitute to doing the real calculation."
Increase Your Scope
Relativity makes us do weird things, Ariely says. We might not think twice about paying $3,000 to upgrade to leather seats in a $25,000 car, but we won't spend $3,000 on a new leather sofa -- even though we might actually spend more time couch surfing than driving. We'll add $200 to the cost of a $5,000 renovation project for upgrades, but also clip a 25¢ coupon for a $1 can of soup.
There's no way around relative thinking, Ariely says, "but we can expand the circle of relativity to include more things that really matter to us. Think about what else you're giving up for $20,000 -- it could be five years of one-week vacations in Hawaii, or paying off your credit cards and having more wealth in the future.
"The trick in relativity is to understand that we do it and increase the scope of relative comparison," Ariely continues. "It's not a magic way of solving the relativity problem, but it is a way to try and make it a bit more representative of our preferences."
Know What You Value
A key here is to get crystal clear on your deeper values.
If you know, for example, that your highest values include living debt-free, education, and creating memorable experiences with family and friends, you'll be more apt to make smarter comparisons: The porch versus enrichment classes for yourself or the kids, paying off a loan, or taking an annual trip that adds up to a lifetime of memories.
And while relativity helps us make decisions, it can also make us miserable, Ariely writes, because jealousy and envy are often the consequences of comparison. The trick is knowing when to widen the circle of relativity (compare that screened-in porch to all the other things you value) and when to narrow the circle of relativity (don't compare your net worth to anything but your own goals).
It's All Arbitrary
Another set of irrational -- and predictable -- behaviors occurs around what Ariely calls "arbitrary coherence."
"We have a very hard time computing the inherent pleasure that things will give us -- that's the arbitrary part," says Ariely. "Coherence occurs once we've made the decision. We assume it's reasonable and we make future decisions in a coherent manner." In other words, initial prices are arbitrary, but once they're established in our minds they shape future prices and make them coherent.
For example, people who move from high-cost cities to low-cost cities (New York to Pittsburgh, say) will often spend the same amount on housing because they're anchored to the prices they previously paid. (The solution? Rent until you readjust to the new context, and create new anchors.)
The Market Decides
The funniest part of arbitrary coherence is that the brain will hook onto random anchors.
In one experiment, Ariely had his students bid on a number of items listed on a sheet of paper -- a cordless keyboard and mouse; a bottle of wine; a design book; and a box of chocolates. But first he had the students write down the last two digits of their Social Security numbers at the top of a page.
Weirdly, the students who had Social Security numbers that ended in high digits -- from 80 to 99 -- bid from 216 to 346 percent higher than students whose social security numbers ended in the lowest numbers (1 to 20).
The bottom line is that what consumers are willing to pay can be easily manipulated because we don't have a good handle on our preferences, or the prices we're willing to pay, Ariely notes. Standard economic theory suggests that forces of supply and demand are independent, and that consumers' willingness to pay is what influences market prices. In reality, it's the market prices themselves that influence consumers' willingness to pay.
Thus first decisions resonate over a long sequence of subsequent decisions. "You can't say, 'Well, I'll just try it once and see how it is,'" says Ariely. "We have to realize that the first decision we make actually matters a lot. And the second thing is to look back into our habits and say, 'How did we get into this situation that we have this many cars or this size house? Do we really value things in the way we pay for them, or was it a random starting point?'"
Anticipating Irrationality
Moreover, be conscious about "trading up" to a new level of consumption, because it's unlikely you'll ever go back, Ariely says. And take time to occasionally inventory your anchors. Look at choices that once seemed completely reasonable; do they still make sense in your current financial situation?
In some money situations, thinking should be removed from the process -- like saving for retirement, Ariely says. A variety of studies have found that forcing constructive behavior by automating a decision -- such as having money taken out of a paycheck and invested for retirement week after week -- solves the problem of procrastination.
Although irrationality is commonplace, Ariely writes, it doesn't mean we're helpless: "Once we understand when and where we may make erroneous decisions, we can try to be more vigilant, force ourselves to think differently about these decisions, or use technology to overcome our inherent shortcomings."
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