October 14, 2013

Book review: Predictably Irrational by Dan Ariely


Written by Dan Ariely, the book Predictably Irrational is a bestseller that promises to answer questions like, "Why do our headaches persist after we take a one-cent aspirin but disappear when we take a fifty-cent aspirin?" and "Why do we splurge on a lavish meal but cut coupons to save twenty-five cents on a can of soup?" It will also explain why the salaries of the top CEOs have increased so much, you can find the answer here. You can say that the basic idea is thus to tell the reader why we humans are not making rational decisions. This knowledge can be very useful. We can "trick" our neighbors, co-workers, and customers - but above all, we avoid getting tricked ourselves.

In economics, rationality provides the foundation for economic theories, predictions, and recommendations. The rational economic model says that we are capable of making the right decisions for ourselves. But humans are not rational - we are irrational - and we are not only irrational, we are predictably irrational. Our irrationality happens the same way over and over again.

There are several books within the same area - another well-known is Influence by Robert Cialdini. Before I began reading Predictably Irrational, I had already studied Influence, so I thought they would be similar to each other. It turned out that some of the conclusions from both books are similar to each other, but they are explained in different ways. So to get most out of the field, and if you have a time to spare, you should read both books. The main difference between the books is that Predictably Irrational talks more about the financial markets, so if you are interested in the financial markets and have only time to read one of the books, you should read Predictably Irrational. The book begins with a common conversation from the financial markets:
- When there's a lot of money on the table, people think especially hard about their options and do their best to maximize their returns. One person makes a random mistake in this direction, another makes a mistake in the other direction, and, collectively, all these mistakes cancel each other out.
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Doing their best is not the same as being able to make optimal decisions. What about Enron? What about the incentives of money managers, who make big bucks when their clients do, but don't lose anything when the opposite happens? In such environments, where misaligned incentives and conflicts of interest are endemic, people would most likely make the same mistakes over and over, and these mistakes would not cancel each other out.

The problem with the financial markets is that it's almost impossible to determine who's right. To determine that, we would have to make several experiments, but we can't run one version of the stock market multiple times. We can save historical data and try to draw conclusions from the data, but the financial markets consist of more parameters that's impossible to simulate because humans engage in actions and make decisions that are often divorced from rationality, and sometimes very far from ideal.

After the financial crisis of 2008, the former chairman of the Federal Reserve, Alan Greenspan, explained how shocked he had been when he realized the financial markets didn't work as he had anticipated. The markets should have automatically self-correct as described by theory - but they didn't. He said he made a mistake in assuming that the self-interest of organizations, specifically banks, was such that they were capable of protecting their own shareholders. What we've learned is that we can't rely on standard economic theory alone as a guiding principle for building markets and institutions. It has become clear that the mistakes are not random, but part of the human condition, or:

"In theory, there's no difference between theory and practice, but in practice there's a great deal of difference."


To explain why we are so predictably irrational, the book consists of thirteen chapters. In the latest version of the book, you can also find a chapter where Dan Ariely discusses why the 2008 financial crisis happened and its consequences and what he believes should be done to avoid a similar situation. Each chapter covers one topic and the proof consists of experiments made by the author and his co-workers. The test-subjects in each experiments are generally college students.

Each chapter in the book includes several examples from the non-academic world. One interesting example described why humans are fooled by the word "free." The online store Amazon wanted to sell more books and promised their customers that if they ordered books for more than $30, the shipping of the books would be free. As you might suspect, the amount of books ordered from Amazon increased everywhere around the world - everywhere except in France. What the French division of Amazon had decided to do was to not offer the "free" shipping, but "almost free" shipping. The French customers had to pay $0.01 for shipping if they ordered books for a sum above $30 - and that $0.01 had made a big difference on the number of books the French customers purchased. When the French began to offer free shipping, the number of books ordered from France increased.

So if you haven't read Predictably Irrational, you should read it. Alternatively, you can read Influence since both books are quite similar to each other. No matter which of the books you read, I promise you will learn something useful and hopefully make fewer psychologically mistakes in your future life.