Predictably Irrational - How Investors Frame Decisions

Dan Ariely

One of the most provocative sessions at last week’s Schwab Impact conference was given by Dan Ariely, who deftly summarized his current research in the important field of behavioral finance.  Ariely is a professor of economics at Duke University and a visiting professor at MIT’s Media Laboratory.  He is also the author of the popular book, Predictably Irrational.

Ariely’s message was that, no matter how good their intentions or how deep their experience, people – investors specifically – consistently make the wrong decisions.  They behave irrationally, and predictably so. 

Advisors who understand the natural biases in individual behavior can frame questions that will steer their decision-making process in a more rational – and economically better – direction.

How to remove a bandage

While serving in the Israeli army, Ariely was injured in an accident and suffered third-degree burns over 70% of his body.  A painful aspect of his long recovery was the process of nurses repeatedly removing and replacing the bandages that covered his wounds, in sessions that often lasted an hour.

His nurses removed his bandages as quickly as possible, leaving Ariely to question whether removing them slowly and methodically would be less painful.

His experience inspired him to conduct a series of experiments into the psychological effects of enduring pain.  He found that:

  • Prolonging a painful experience does not make it much worse; it is changing that amplitude of pain that makes the experience much better or much worse
  • Pain that starts at a low level and gets high is much worse than the reverse
  • It’s good to take breaks when dealing with pain, to provide a chance to recuperate

The nurses were wrong, despite having their years of experience and good intentions. 

Ariely’s subsequent research has focused on understanding why people make consistently wrong decisions, in spite of conclusive evidence that should lead them to the correct decision.

Optical illusions and the power of the default option

Ariely showed the audience a familiar optical illusion, asking them whether the length of the table on the left is greater than the width of the table on the right: :

Optical Illusion

The audience’s selections mirrored the results in Ariely’s experiments showed that people consistently chose one table over the other, despite the fact that both are the same length.  “Your brains are fooling you in a repeated, systematic way, and they are doing the same for everybody,” he said. 

Vision is one of our most reliable senses; it occupies a significant portion of our brains and we use it constantly throughout the day.  Investors make decisions far less frequently and subconscious biases that operate in the context of complex financial choices can lead to even more frequent wrong decisions and, consequently, economic harm, Ariely said.