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taking stock

When the financial world came crashing down in 2008, Dan Ariely realized he would he tempted to do something drastic to his investment portfolio that he might later regret. So he deliberately punched in the wrong password enough times to lock himself out of his online brokerage account.

"I did it after I made a mistake," says the professor of behavioural economics at Duke University in Durham, N.C., who often uses his personal experiences as a springboard for his research into why people do the seemingly irrational things they do.

"What happened was that when the recession started, I kept on checking where I was [financially] Every time I lost money, it kind of ruined the next few hours of my day. A year of savings was gone in one day of randomness. But I also didn't feel my allocation was off. There was nothing specific I wanted to change. And I wanted to separate my emotion from my decisions."

That's not something most of us are capable of doing, because of very human tendencies that run counter to rational investing, says Prof. Ariely, 42, an Israeli native who has emerged as a prominent voice in the hot field of behavioural economics.

"We are all far less rational in our decision making than standard economic theory assumes," he declared in his 2008 book on the subject, Predictably Irrational: The Hidden Forces That Shape Our Decisions. But as the title indicates, the irrational in us is neither random nor senseless.

Two of the key roadblocks that keep most of us from becoming the next Warren Buffett are known in psych-speak as anchoring and loss aversion.

Put simply, we can't help focusing on how much we paid for something (the reference point or anchor that affects how we value it), and we really hate losing money. When translated to the marketplace, the upshot is that we tend to stay with losers too long and sell winners too soon.

"The fact that you remember the starting point creates the loss aversion," Prof. Ariely says affably between sips of tea. "Losses loom larger than gains. It's more painful to lose, so this tendency grows even stronger by keeping losers for too long. And even when you're making money, you worry about losing it."

He illustrates this with a time-tested student experiment, offering a bet on a flipped coin. If the coin comes up heads, you win $100. If it's tails, you lose $80. If your instinct is to reject what is actually a good gamble out of a fear of losing, you shouldn't be investing in the stock market.

We also seek to avoid any regrets, which typically causes us to run with the herd, another obstacle to market success. "We have an instinctive initial reaction to assume other people are doing the right thing."

The stock market and commodity gains of recent months are a case in point.

"You're seeing all your friends investing in X, which could be gold, oil, indexes, whatever. It seems like everybody around you is doing the right thing, aside from you. So every day that you are not in this market and your friends are, you feel like an idiot."

Yet more investors are talking a bullish game than playing one, because money is still pouring into fixed income. And if you asked most people their view of economic fundamentals, few would say things are going particularly well.

"In some sense, everybody has learned a little bit too much economics," he says, by which he means "the Chicago school of rationality" has permeated popular thinking.

An Investor's Guide to Understanding the Economy:

  • Part 1: How the money in the economy is managed
  • Part 2: How inflation works
  • Part 3: Avoiding the deflationary spiral
  • Part 4: How much money is too much money?


"It's somehow in the air, it's in the politics. I don't know where people are getting this deep belief in the rationality of institutions and markets," says Prof. Ariely, who describes himself as a conservative investor who didn't see the bust coming.

The all too human traits he describes "make for very bad behaviour in markets. If you think that markets are supposed to be [made up of]these independent, cold, calculating actors who work against each other in the hope of getting a joint outcome to be better, human nature doesn't create a good recipe for that," says Prof. Ariely, who signs off his notes: "Irrationally yours."

Bank directors should make a point of getting their hands on his next book, Perfectly Irrational, due out in June. He will reveal the findings of his research into the impact of fat bonuses on the performance of those who receive them. As many of us have long suspected, the huge incentives - and the stress that comes with trying to achieve them - make for less productive people.

"In the experiments we show that they're counterproductive," Prof. Ariely says.

Now that's one irrational behaviour worth stamping out.

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