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September 22, 2009
The role of emotions in decision making
“When it comes to emotions, we have two sides to ourselves,” Ariely said. While we may have good intentions, for example when it comes to healthy eating, those intentions are often compromised in the face of temptation.
Part of the role of advisors is to help clients avoid the injurious effects of temptation.
Most people choose to have a half box of Godiva chocolates immediately, rather than full a box in a week. But given the choice of half a box of chocolates in year, or a full box in a year and a week, most people choose to wait the extra week for a full box.
Ariely calls this bias hyperbolic discounting. When decisions affect events further in the future, people act more rationally. As time frames shorten, temptation plays a greater role and decisions become more irrational.
Hyperbolic discounting explains why people don’t save, diet or exercise – the rewards of immediate temptations are valued too greatly.
To counteract temptation, clients can create binding contracts with themselves to avoid it. Those contracts need to be drawn up before the temptation arises, and must specify exactly how the investor plans to behave in certain circumstances. For example, a contract might specify how the portfolio will be rebalanced if the market goes down by a certain percentage.
“Advisors need to see if they can be this bridge between their clients’ long-term goals and short-term impulses,” Ariely said.
The power of trust and revenge
Ariely described an experiment where player A has the choice of receiving $10 or giving the $10 to player B. If he gives it to player B, the money quadruples and player B has the option to give $20 back to player A.
The rational choice is for player A to keep the $10. Experiment results, however, show that people are really nicer than theory predicts – player A ends up doing better by giving money to player B, because player B will reciprocate.
If player A is given an additional choice – to spend a dollar to take two dollars away from player B in cases where player B has betrayed him – most people will do so, despite the fact that the decision is irrational.
Swedish scientists showed that those people contemplating revenge have brain patterns resembling pleasure, which helps explain why revenge is frequently sought-after.
“This seemingly irrational tendency for revenge is actually inherently useful,” Ariely said, because people understand that if they betray trust, others will go to extremes to seek revenge.
Trust is difficult to restore, Ariely said, and this is challenge faced by regulators and the investment industry in the wake of the financial crisis.
Some final thoughts
Ariely concluded with these five points of advice:
- The advisor’s role is to guide decisions, and to understand what your clients can and cannot compute. Be wary of the curse of knowledge: When you know something well, there is a tendency to assume others know subjects as well as you do.
- Your job is to aid clients and be an expert.
- Think carefully about choice architecture, defaults, and decoys.
- Emotions are a powerful force in short-term thinking.
- Clients are irrational, and an advisor’s job is to protect them from that irrationality.
“You are not just an impartial observer who allows people to express their preferences,” Ariely said. “You have a huge influence, through the questions you ask, and a huge moral burden to get clients to think about choices in the right terms.”
Ariely went back and talked with the nurses who treated him to ask why they insisted on pulling off his bandages quickly. They said his analysis failed to take into account the emotional pain that they experience during the process, but they quickly agreed that was not the goal of the treatment.
The nurses explained that their reluctance arose from two factors: pulling the bandages off slowly was against their intuition, and it would cost them additional time.
Acting against one’s intuition can be incredibly difficult, and Ariely urged advisors to carefully guard against that bias. Be careful of decisions that are not based on data or evidence, and always ask what kind of tests can be constructed to test your assumptions.
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