Saturday, December 10, 2011

Predictably Irrational: Chapter 1

Dan Ariely is a behavioural economist who refutes the idea that we are fundamentally rational. Through empirical data, experiments and anecdotes, he illustrates that our irrationality can actually be predicted. He then presents ways in which we can make more rational decisions, both as investors and as people.

This chapter is about how obsessed we are with relativity. We have a very hard time judging the value of the things around us on their own. Therefore, we always compare them to similar things (e.g. vacations to vacations, tvs to tvs etc.), and this leads us to make decisions favouring items that are clearly relatively superior.

For example, the author reproduces an ad for a subscription to The Economist, where the subscriber has three options:

1) Web-only: $59
2) Print-only: $129
3) Web+Print: $129

Clearly, Option #2 is inferior to Option #3. When the author asked subjects which option they would choose, 16% chose Option 1 and 84% chose Option 3. But in another experiment, when Option 2 wasn't even available, 68% of subjects chose Option 1 with only 32% choosing the more expensive option. The decoy option (#2) was placed in there to affect behaviour by getting more people to choose Option 3. It works because we make decisions based on relativity.

Ariely goes on to describe how this bias affects whom we choose to date, CEO salaries and many other phenomena. To make better decisions, he suggests thinking more broadly than your natural tendencies would prefer. For example, when confronted with a decision to pay a few hundred for an option in a new car, don't compare the few hundred with the price of the car (which would encourage you to buy the option, since the price of the car is high relative to the price of the option). Instead, think of other things the few hundred could buy (vacations, books, electronics) in order to avoid falling prey to relativity.

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