The Upside of Irrationality - Investment Insights

Last Updated Jun 12, 2010 7:02 PM EDT

Sometimes the best investment books aren't even about investing. Dan Ariely's phenomenal new book, The Upside of Irrationality, is a perfect example. In the same fascinating style of his previous best seller, Predictably Irrational, Ariely exposes both negative and positive consequences of human irrationality.

I had the great fortune of interviewing Dan Ariely last week, and below are some lessons from the book that can be applied to irrational investing.

The case for revenge
Not only is revenge a dish that is best served cold, but it is also a dish that gets served more often than McDonald's serves burgers. If you've ever entertained thoughts and plans of revenge, rest assured that you are not alone -- human nature is such that we like to exact some sort of punishment when we feel we have been wronged. It certainly seems logical that we would want to punish the party that wronged us, but Ariely's research shows we don't much care whether we are punishing the party that wronged us directly (the agent) or someone that hired the person that ended up wronging us (the principal). Either way, heads must roll.

With that in mind, I asked Ariely why he thought investors were still trusting Wall Street after the financial meltdown. After all, their incompetence, greed, and indifference to the fallout caused millions of investors to lose huge chunks of their life savings, and that seems like a revenge-worthy wrong. Investment companies needed bailing out, and shouldn't still be handing out investment advice. Yet I've heard investors state their intention to stay with their brokers because the brokers didn't cause the meltdown. True, but they were the agents, so why didn't investors leave in droves?

Ariely observed that the reason investors stayed with their brokers was because they had no one to trust. If they had a viable option to trust with their investments, you can bet they would have punished their brokers with a mass exodus not seen since Moses. On top of that, the financial meltdown demonstrated that nobody had any idea about what was going on, not just the individual advisors. And so, ultimately, the personal relationship investors had with their brokers trumped the desire for revenge.

On empathy and emotion
In 1987, Baby Jessica, was trapped in a well for 58 and a half hours, while the media kept our nation riveted for every one of those hours. Strangely enough, the plight of this one child garnered more national attention than the 800,000 Rwandans that died in the 1994 genocide. Baby Jessica received more national attention because we could more easily identify with a victim we can put a face to rather than "statistical victims."

Applying this principle to investing, there is conclusive data that expenses and emotions rob us of higher returns and diminish the power of compounding. So I asked Ariely how to reach investors beyond this cold statistical data that we can't relate to. Ariely responded that a SimCity type of game, simulating the consequences of our own behavior in saving and investing, would likely have the emotional appeal to cause us to act inline with what is better for us in the long term. The game could then help us imagine what life would be like spending our retirement years in a double wide versus a comfortable lifestyle pursing our passions and dreams.

The hedonic treadmill
We think that having the nicest car in the neighborhood will make us happy. We then adapt to the expectation and, after a few weeks, the high level of happiness vanishes. Then we must buy something else to again make us happy.

So I asked Dan what research had been done to determine the factors that will cause someone to get off this hedonic treadmill. How can they learn to defer immediate gratification to save for future goals, such as financial independence? Ariely acknowledged that there was very little research in this important area, but did offer the advice of using rules to jump off the treadmill. For example, putting twenty percent of our pay into retirement accounts is a rule that we are surprisingly quick at adapting to the lower expenditure rate.

When markets fail
Ariely compares market failures from the financial crises to dating websites. In the interview, he also pointed out the many failures of my profession -- financial planners. We often tell you how much you will need for retirement without helping you imagine what type of lifestyle you will have. We convince ourselves that the fees we charge don't take from your return. And, of course, we present products such as annuities in such complex terms that no one can possibly understand, requiring investors to blindly trust us. In the book, Ariely states annuity salesman "are the insurance industry's equivalent of the used-car salesman."

Why you should read this book.
I'm not typically given to hyperbole, so when I say that The Upside of Irrationality is one of the best books I have ever read, it is. I've never met Dan Ariely, yet reading his book made me feel as if he had a window into my irrational behavior for the last couple of decades, and wrote about some of my worst behavioral flaws. But it also showed me the upside of human behavior such as trusting others, adapting to new circumstances and our ability to care about others.

I read this book with my own biased views and may be the only person reading it with the purpose of applying Ariely's brilliant research to investing. You may want to ask yourself whether any of the behaviors above are contributing toward you being an irrational investor. You'll probably want to read this from a more general perspective as noted in Jill Schlesinger's column on bankers' bonuses or her recent interview with Dan Ariely.

While learning about my own irrational behavior was my primary reason for reading the book, the utter enjoyment I received from Dan Ariely's engaging writing style was just icing on the cake.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.