When it comes to making decisions, we think we’re making rational choices. But are we? In Predictably Irrational, behavioral economist Dan Ariely asserts that we’re far less rational than standard economic theory assumes and refutes the common assumption that we behave in fundamentally rational ways.
According to Ariely, our behaviors aren’t random. They’re systematic and predictable – making us predictably irrational. Understanding why we’re predictably irrational, and recognizing the patterns, provides a starting point for improving our decision-making.
HUMANS AND HEURISTICS
We’re confronted by a tremendous amount of information daily, yet our brains are only capable of processing a certain amount. If we tried to analyze every single aspect of every situation or decision, we’d never get anything done. In order to cope and speed up the decision-making process, the brain relies on heuristics. These mental shortcuts, which Ariely calls “hidden forces,” help to simplify things so we don’t have to spend endless amounts of time analyzing every detail.
Behavioral scientists have documented hundreds of heuristics that influence human decision-making, many of which are deeply rooted in our DNA. Our brains have evolved to seek “shortcuts” that reduce effort, and as such, we rely heavily on habits and intuition to reduce our cognitive workload. Additionally, because we tend to be very social creatures by design, the decisions of others often strongly influence our thinking, either consciously or subconsciously. Finally, because we don’t always have the time or energy to consider situations analytically, we often let our emotions guide our decisions and behavior. Ultimately, these shortcuts or hidden forces are necessary in helping us navigate our lives, but they can lead us astray.
THREE HIDDEN FORCES INVESTORS SHOULD KNOW
While Ariely catalogs a host of hidden forces that affect our day-to-day decision-making, the following three have important implications for investors:
1. Procrastination and Self-Control
We all struggle with self-control. As Ariely puts it, “resisting temptation and instilling self-control are general human goals, and repeatedly failing to achieve them is a source of much of our misery.” The good news is there are tools we can use to help us better manage our impulses. For example, we tend to procrastinate less if our deadlines are clear and we know them in advance.
Complete flexibility doesn’t seem to help, but being able to set our own deadlines does. As investors, our lack of self-control can lead us to misguided investment decisions, such as changing our portfolios too frequently or spending instead of saving.
Ease is also important, as Ariely demonstrates in his Ford/Honda service case example. Ford originally instructed its customers to have their cars serviced and parts replaced when needed, which was technically correct but confusing (because some service was needed at 10,000 miles and others at 15,000, etc.). But, Honda “made it easy” by providing “service bundles” that clearly instructed customers when service was needed – after a certain number of years of ownership or mileage. These bundles worked so well – customers had their cars serviced when they were supposed to – that Ford applied the same principle and the use of their service bays took off.
Precommitments can help as well. Because we tend to value the short-term more than the long-term and have difficulty making tough decisions that “hurt” immediately. Precommitting (to savings, philanthropy, etc.) puts this “pain” in the future and makes it easier to do. Investors looking to save more for retirement, for example, can set up automatic plans by scheduling a recurring deposit from your checking account, or paycheck, into a linked savings or investment account.
Precommitments can also be applied to your portfolio’s risk/return objectives. Clearly defining your objectives up front can help you retain self-control of your investment decisions going forward. Without well-defined objectives, it can be much easier to lose self-control and give in to temptation. The key with precommitments is to make the good decision in advance, which makes us less likely to give in to temptation.
People rarely choose things in absolute terms. Instead, we are always looking at the things around us in comparison to others. This is true for physical and ephemeral things like attitudes, and points of view, as well as more tangible experiences or decisions such as choosing our vacation or buying a home. Here’s an example from Ariely that highlights the problem of relativity – how we look at our decisions in a relative way and compare them locally to the available alternative:
“When Williams-Sonoma first introduced a home ‘bread bakery’ machine, most consumers weren’t interested. Flustered by poor sales, the manufacturer of the bread machine introduced a larger more expensively priced model. Soon sales began to rise on the original, smaller model. Why? Because consumers now had two models of bread makers to choose from; they didn’t have to make their decision in a vacuum.”
For investors, relativity can rear its head in a number of ways. For example, comparing the returns on your investment portfolio (designed with your specific financial objectives in mind) to a broad market index that is not consistent with your portfolio objectives, or the returns a friend’s portfolio may be generating, is not the best way to determine investment success or make investment decisions.
3. Endowment Effect
People tend to overvalue what we have and discount the value of things we don’t have. Here’s an endowment effect example from Ariely: At Duke University, basketball games are heavily oversubscribed. People who weren’t able to get a ticket were asked how much they would pay to get one. The most someone was prepared to pay was $170 – about twice its face value. However, when those who had managed to get a ticket were asked how much they would be prepared to sell it for, their average was $2400 – 14x more.
When it comes to investing, the endowment effect can cause you to hold on to assets that no longer make sense for your portfolio and ignore new investment opportunities. Additionally, investors show a natural tendency to put money into what they already own rather than considering new investments, which could mean passing up an investment that may be a better fit.
STEPS TO MANAGING YOUR IRRATIONALITY
Managing your irrationality, especially when it comes to investing, takes both awareness and practice. A good place to start is to consider the hidden forces, or heuristics, that may come into play when you’re faced with investment decisions. Remembering that we’re prone to relativity, especially when you’re comparing your investment results to benchmarks that aren’t consistent with your portfolio objectives, can help you maintain a long-term perspective.
Developing the right processes, like precommitting to a savings or investment plan and sticking with it, can help keep self-control struggles at bay and lead to better investment outcomes. Likewise, understanding that guidance and transparency can help you make better investment decisions gives you a framework to seek out the information you need and ask the right questions.
Finally, knowing that we tend to overvalue what we already own can go a long way in the investment process. If you’re holding on to something simply because you already own it, consider that you may be missing out on opportunities that are better aligned with your long-term goals. As Ariely says, “With everything you do, you should train yourself to question your repeated behaviors.”
BEHAVIORAL SCIENCE IN ACTION
PIMCO has long understood that behavioral science can make us better investors. That’s why we’ve partnered with some of the best minds in the field at the Center for Decision Research at The University of Chicago Booth School of Business. Through this innovative partnership, PIMCO supports diverse and robust academic research that contributes to a deeper understanding of human behavior and decision-making. Learn more about how behavioral science can make you a better investor.