Dan Ariely and the Behavioral Economics of Debt

alright well I'm here with Dan Ariely and we're Duke University and of course you are a a world-renowned behavioral economist I'll give you some and I followed your work for a long time and I've read your your books they've written on the subject and there's been a lot of work about how people get into debt about the things that drive them to spend or overspend yeah and I wanted to talk to you today about what are the issues that prevent somebody from getting out of debt mm-hmm yeah so so first of all some of those causes are the same so one of the big issues is temptation right so you walk by a supermarket to car dealership whatever it is and they are designed to tempt you to take an action now and if you think about the whole system around us is trying to fight for our money right now not caring about what we will do in the long term and we get tempted and as we get tempted the system gets better and better and figuring out what what tempts us so if you think about this we call this hyperbolic discounting the idea that now is more important the future that's what gets us into trouble and it's what gets us to have a difficult time getting out so let's think about the standard example imagine I asked you what would you rather have a half a box of chocolate right now or a full box of chocolate in a week mm-hmm and imagine I headed here so you can look at it and smut and say half a box of chocolate now or a full box of chocolate involved with the temptation d'etre that's vast majority of people do that now imagine if I push the choice to the future and I said what would you rather have a half a box of chocolate in a year or a full box of chocolate a year in a week now I can wait that's right now the discount rate is the same it's another half a box of chocolates for another week the problem is that now you say I can't wait but in the future we are wonderful people in the future we will say if we will exercise we will not spend we will take a medication on time we'll die it will do all of those all of those things so it's the focusing on the present did you get us into trouble and also get us it makes it difficult to to get out of it in fact there's some economic and analysis economic analysis of why is it never rational to stop smoking because every single cigarette will not kill you and it will give you pleasure so should you stop no you should have one more cigarettes one more and one more and one more and if you do lots of those things it really undermines the future the same thing goes about saving saving is really about the future if you're tempted about now it's about not having now so you can doubt in the future another thing is the first thing and and the question is how do we fight it the second thing which again is both the complexity and the and the reason is that it's really hard to think about money if you think about it money you know we make decisions with money all the time and because of that we think we're experts but the reality is that we're not funny is really hard to think about every time you buy a cup of coffee you should intuitively think what else you could do with these 250 really hard to do right that would require consciousness it would require lots of computation what what are the substitutes now in the future actually we went to Toyota dealership okay and we asked people what will you not be able to do in the future if you buy this car people were shocked by the question there is no connection whether there was no connection what do you mean isn't it well know if you buy this car something would give what the most people would give us was if they buy a Toyota they come by Honda no they were substituting in the same time frame in the same category they were buying regardless well they were just not thinking about the opportunity cost right there were nothing about if I buy this car it means four weeks less of vacation and 70 less booked and 300s lattice that's the intertemporal substitution but the problem is just too hard to think about but money is all about opportunity costs but opportunity cost is incredibly hard to think about because every dollar you spend could go to so many many many different things but you don't really know what you get it in fact imagine the following imagine I was going to give you $10 how happy would you be and imagine that I spent nine dollars to buy you a gift can you think about something I would buy you that would make you happier than the cash any cash that's the rational thing right but I'm asking not saying what would you take I say can you imagine something to make you happy yes so can you imagine a CD that I could buy for nine dollars they don't make you actually happier than ten dollars or if instead of giving you three dollars in cash can you imagine I gave you a nice cup of coffee and you would be happier than that if it happens to a lot of people with lots of products and the reason is that when we get money it's so ambiguous it's so general it can go to so many different things we don't know exactly what the hedonic value of this is so we have two things we have money is incredibly abstract very hard to think about and temptation is killing us all the time do you think that people make the connection between debt and future labor that they understand that in order to repay this they're going to have to maybe work at a job that they hate or work harder I don't think that people make these specific translation because you would need to make a very specific translation you have to think well this would mean two more years of work or something very specific but if I ask me if you buy another car today what would give it so how to pinpoint and you know they the current economic situation only the recession I mean the economic flexibility makes it very hard to think about we have credit cards and student loans and mortgages where exactly are we what's our financial situation really really hard to figure out if I gave you an envelope and I said this is your budget for the month every time you would take $100 you would see it going away and you could calculate we give me boundaries yeah but without it but where are we what when should you stop how much loan is it okay to get how it affecting your life quality and in fact I think this is a big mistake of the financial service industry is that we assume that people kind of can compute the opportunity cost of money the impact of spending now in their future lives but people can't know and the tools we really need to create for people are tools that help them understand these trade-offs if you live in a bigger house now if you buy a new car what does it mean what will give and if we could visualize it for people in a compelling way I think it will change your behavior but right now they're behaving as if nothing will give now when people get credit creditors extend money to them and they run into some unforeseen problem creditors say that is their problem they took the money out there solely to blame but to do creditors who use tools and techniques to entice somebody subconsciously to take their product do they have any share of responsibility it's not subconsciously I mean you can also think about mortgages but you can say if somebody took a bigger mortgage and then they could reasonably repay whose fault is it and you know in the real world you know you're a big boy you can decide what what you do and if you take the risk but I think it's not like that exactly um you know if I put here a plate of fresh doughnuts and I pump the smell of fresh baked goods into this room odds are you'll be tempted mm-hmm and what are you will be tempted even if you don't want to and I should accept some of the responsibility for that and people who sell credit and give mortgages they are trying to tempt people to take too much and they're successful so I think that it's a little bit unethical or non genuine to say well you took it and the other thing is that the more I do research on kind of behavioral economics and human fallibility the more I realize how difficult decisions really are and and I give lots of talk to doctors these days in hospitals where doctors have the same idea they say I'm just a doctor you're the patient Who am I to tell you what to do I'll just give you a list of papers to read and tell you the probabilities of risk and you will make the informed decision it's crazy right it's crazy and doctors are pushing responsibility partly because they have no time to spend with the patients and part it on the legal responsibility or the emotional responsibility but the truth is it's really hard to imagine that the patient in that current mind state state of mind could actually become an expert in medicine and I think the doctors have fiduciary responsibility to actually recommend treatments they are the experts that's what we go to them for and I think in the same way I think there's fiduciary responsibility not just in exposing the information but doing the deal that is actually in the best interest of the client it's not doing that is actually betraying the principles of the profession now when people have my natural problem see years ago about ten years ago we did a study of clients and people that were suffering could not pay their bills and we found out that 40% of them met the definition of clinically depressed uh-huh so when somebody is in that state of mind yes is it harder for them to make rational decisions so this is it's a very interesting question the answer is not clear there's some results showing the people who are depressed actually see reality more correctly you know all of us have what's called an optimism bias we think we're better drivers than average we think we're probably better investors than average we're less likely to die of a heart attack you know we are overly optimistic and there's some results showing that depressed people actually more accurate yeah now being more accurate doesn't mean that they necessarily have a better life but it's not clear that they would be irrational the same irrational aspects the same way there's some beautiful results showing that people who have actually frontal cortex damaged rely cans and some condition make better investments oh and if you think about it you know we have a brain and we have different parts of you that do different things and some of them have both positive effect on our ability and negative parts on our ability so sometimes when you knock one of them off people actually make can make better decisions I'll give you one trivial example and one mistake people do in investment is they think about the past you bought the stock at 100 today is 50 you think it's going to go to 30 but you really don't want to realize the loss so you keep on holding it imagine you had no memory of what you did in the past right office and you say heavy stock at 50 I don't know how he got there but I mean I want it you would not feel attached to what you've done before so it's kind of interesting to think that some of our big cognitive assets are also liabilities in some cases well people that are struggling one of the best solutions for them in a difficult situation is bankruptcy yes but there is a societal stigma against bankruptcy and they automatically discounted as not an option so so my some of my friends in banking have told me that this stigma is going down that it's less and less well I think that more people are filing bankruptcy but it's because their situations are worse yeah no but the question is is the value of the stigma lower right I don't think so you don't think so you think that the fact that the Citibank and AIG and all the big bailouts don't make people more well no not the bailout the problem I run into is that more people are having to go bankrupt because the creditors are unwilling to work with them yeah no no I understand that and then the more that they drive people into bankruptcy that I think effects the stigma a bit yes and of course if your neighbors declare bankruptcy you probably feel okay about it as well so the question is and do people feel better about it and if they feel better about this because of the neighbors or because of big corporate bailout and and then the separate question is are people just have less access to credit and because of that they have to well the problem I see are that people in financial trouble they are a great target for scam and fraud yes and so people are out there making all sorts of grandiose promises saying if you give me $2,000 I'll help you out of your jam and they are more attracted to that than they are to overcoming whatever bias they have against bankruptcy yeah so you know I again I have some friends that are in service the service lending service of mortgages and they say they call people with good offers to refinance and they just known as doctor because they've been burned woman before so I think it's a terrible situation right so there's something called the tragedy of the Commons you know the expression now so it started from in Boston in the common garden and it was the place where farmers could come with a cow and as long as everybody had one cow there was just enough grass for everybody but if a few of them had two cows they would have more money but soon enough there was not enough grass for any cow because the grass was depleting fast it was growing and eventually no the grass was not able to sustain any cows and this is a general example of lots of public resources you know you fish as we fish it we deplete it and it grows back if we deplete it too fast there'll be no more salmon or you know we deplete fish a lot and so but for each individual farmer it's good to over fish because it's good for them in the short term their individual benefit but in the long term everybody everybody loses out and I think and that's what lots of these not just cameras but lots of these banking products do they take advantage of people in the short term mm-hm but then if somebody declare bankruptcy everybody loses all right so I can tempt you with some loan I could attend you do it here over there but eventually you would fail and then everybody would suffer you including but also your creditors so how shall a very set system how do you get somebody passed that point of ashamed and embarrassed to want to talk about their situation it's more personal to them than anything else yeah and see bankruptcy as an option and not be attracted by the lure of the the quick fix so first of all I think that the term bankruptcy is a very unfortunate term it's like generic medicine you feel like something is wrong right you know you know and I think if we call it opening a new page and I think if we connected it with New Year mm-hmm we might we might have a chances so people think of very positively about second chance I imagine it we call it a second chance program or second start and you can't do it too many times but but here's another time you would do it I think people might be more willing to to do that the word bankruptcy it's a really bad negative emotional term that might not do the calculus and the other thing is that it's really unclear what happened to somebody whose bankruptcy in bankruptcy so I think we need to create a different name and make it clear to people where they would where they would be what they would gain what they would lose what's the calculus so named explanation of what it is and then we have what is called social proof this is stuff that children he wrote many years ago about which is the idea that we define what's acceptable and not acceptable by the behavior of others it could be about the behavior of individuals or behavior of many but the moment they are closer to us and more connected to us it is more okay so the fact that people feel shame about declaring bankruptcy they don't tell their friends right there's a barrier nobody has a party without it that's right but if you and if you start getting people who've declared bankruptcy to talk to other people they would feel better it would so this is like the demonstration effect yeah by the way you know it's it's tricky do we want more bankruptcies I don't know you know that is an excellent question because what is right for the individual is not necessarily what's right for the economy it's so where does the sacrifice come should people do what's right for them or should they sacrifice for what's right with the gun yeah and by the way the same thing works for entrepreneurs but for people to open new restaurants they have to be crazy result good for them but you're really good for the rest of us who enjoy trying to eat different food so so it is lots of cases where what's good for society is different than what's good for the for the individual so I think with bankruptcy um we really have to think more carefully about under what conditions we would want who to declare declare bankruptcy there but you know we don't have to go all the way there we can also say what about the people who are just struggling right what kind of thing could they be could they be doing so one of the things we find is that when we leave it to people's Accord to behave as they want there's a good chance they will fail every time so what's the solution the solution is to create a habit that is outside of our hands okay so think about something like automatic deduction yes it happens yeah it just happens you do it once you think oh how much they want to save in the future let me do it in anything outside of your hands if every month at the end of the month you will get to fall from your workplace it says how much do you want to spend it to save this month you know you'll never send him you'll never send the phone back so think about one-time activities that will get the chain of future events to break the cycle to work the second thing is that if you think that money is very hard to do what you want to try and do is in apples to oranges so there are some times people talk about how decision is if it's comparing apples to oranges in English but it turns out comparing apples to oranges is a very easy decision have you ever seen anybody baffled by the fruit plate my goodness my goodness which one which one is now they're all apples but sorry comparing Apple to orange it turns out it's quite easy what's hard is figuring out with an Apple is worth 25 cents 50 Cent's 75 cents a dollar 50 so we fail when we map the expected pleasure from something to money but when we think about things directly against each other it's actually easy so if I say should you buy a new tennis racket 450 really hard to figure out but if I say what else could you do with $150 what could you get and with those things give you or lesser pleasure and this now you can figure it out so that I think is another thing is to start making apples to Orange calculation another trick of course is to start using cash because then we it's harder to not to keep track actually a very good method is to I create multiple envelopes and create these envelopes per four different buckets actually one of my friends delete someone did a nice study in northern India this was a place where migrant workers come to work and to send their money back to their family and as you can expect in a place that lots of men come to work lots of temptation appears as well the alcohol gambling prostitution and they end up spending much more of their money on those things and so what deal appeared in one experiment he gave people the money that he would get every week in multiple envelopes and the idea was and they were all sealed and the idea was if you open the envelope you're just going to spend it but you might not spend the next one and he actually saw that behavior saya juice that's right okay the other thing he did which was a bit stronger was he wrote in the name of their kids and some of the envelope and now the money was allocated yes the kids in their mind and they were less likely to do it so think about the monthly budget and create some kind of concrete I also notice your steps the people who record their spending each word each goes that they cut back on their discretionary spending about 20 percent just awareness yeah yeah the same thing go with electricity right people get electricity media tells them how much they're using seem to be cutting not 20 but 10 percent and so I think all of those all of those tools are very good and trying to think about other things now I have I have some phones actually one more thing um we've actually just finished a set of studies did asked when people have multiple loans which ones do they pay faster okay and what we found is that people pay the small loans first not the loans with the highest interest rates and I think it's because of the satisfaction of reducing the number of loans right hi great and that's a very sad mistake and actually Ramsey is recommending it right so Ramsey is kind of a finance self self finance guru I can write so but but he's recommending what he called this noble Stratton right which says you close no small loans you'll get used to it and then you will keep on doing it we don't find any evidence for that we find that these strategy harbours and people's bad intuitions to finish small loans so they did those close more long you don't think that knocking off a loan or two gives people an incentive to keep going we don't see evidence for this I mean it could be we just don't see evidence for that and instead we just see evidence of bad advance strategy where you teach people here's what you do you mean the opposite of what's good question from the audience here whose wants to know if there's any evidence that consumers under stress give better more accurate data when they can be anonymous okay so so there's two questions here is do people are distressed give better responses and is anonymity helpful and so so stress is not helpful I think we have lots of evidence saying this stress is just just bad people process information is shallow away they don't think very deeply they focus on on shorter timeframe this is not a good thing and anonymity helps sometimes when you talk about information that is embarrassing or you mean it were very personal that's right and usually what we do as a as a research trick is to ask people what they think other people would do so imagine I ask you a question that you you don't really know what other people would do but I say what do you think people would do so I say let's just let's make it a question about something unethical so saying imagine you were here in my office imagine it's somebody not you somebody else was in my office and I said I had to leave for an hour and I will not come back and I closed the door behind me and I left somebody else here do you think that that person would go into my computer and check my my email now if I asked you about you you would say yeah well but if I say what do you think with somebody now what you have to do is you don't know what other people do you have to ask yourself what do I think somebody like me but without with with morals like everybody else do it now you can sometimes give better answers so that's usually the trick we use we ask people to say what they predict the average person would do is there any evidence that giving people difficult advice like what to do with their their debt problem is more effective over the phone or face-to-face and so I don't think there's any direct evidence for this but we do have evidence showing that people are more compliant when they look at the other person's eyes in fact if I look into your eyes and then I turn away it's less compliant and when I look into your eyes and make the decision while looking into you're honest so if you think about it people don't want to be compliant I mean it's a really miserable difficult thing that we're putting ourselves into so the question is what will force us to do it and I think that people who try to get behavior change you need to bring the forms into the office and need to get people to pre-commit and write letters to themselves and sign things at the moment when they get them to think about the long term so here I am we have a difficult discussion it's complex and I get you to think about the long term now is the time to get you to pre-commit I can't wait half an hour and hope that okay here's the paper go home and fill it out mm-hmm okay I get that do people who accumulate debt is that because of underlying issues and behavioral drivers or is that because they just lack basic money management skills so there's lots of questions in here so it turns out that being poor in the u.s. is very hard for example it's really hard to bank if you're poor yes and you get your paycheck on Friday and then you take the bus and you get back home and there's no Bank open and the only thing it is open is payday loan or check cashing in and they charge a lot of money and now you've just lost 20 percent of your weekly income to this to the service because you can't spend so do you want to call this lack of like lack of skills and not really right it's just like my opportunity actually yeah and then the same thing happens with food so imagine that you went to a new house tomorrow with no food and you had to start equipping a kitchen and you wanted to buy salt and pepper and olive oil and pots and pans you would have to invest a lot of money in order to be able to eat more cheaply yes or you can go to McDonald's right so so they it's even hard to create the conditions to live efficiently so I think that's really working against against the poor but not to mention that if you ever looked at their forms for food stamps yeah or for aids and it's massive yeah a couple of my friends did these gave these forms to people have ph d--'s and and they and they basically gave up or fill them in correctly when you fill those things incorrectly it's not as if a government official is going to correct them for you they send them back and so the combination of lack of transportation lack of banking the lack of ability invest in infrastructure like even even a kitchen that would allow you to eat more cheaply all of those things really really hurt the poor on top of that we developed a banking and financial system that abuses the poor butts rooms so I'll give you one personal story a few years ago I was at Princeton for the year and I was in Israel for a month I came back I discovered my car insurance ran out they mailed me a letter to to Boston by the time we got to Princeton I was out of the country by the time I got to it was up I called my insurance company I said hey sorry I missed it can I send you a check well give you a credit card number they said no once it expired you consider a persona non-grata you have to come in person listen you're joking anyway I called three other agencies they all say the same thing so I took I couldn't drive and I took the train from Princeton to Boston got to the to the insurance company the next thing I learned was that my insurance premium went up by $500 because all of a sudden I lost all the discount there was no longer a good driver and with no this I was you know mm-hmm and then I also they said I have to pay in cash for the whole year you know I happen to have a few hundred dollars on me and I had 2 ATM cards I got another $800 I had enough for half a year mm-hmm I said look I'll give you half a year now I'll pay you the other one in a check in two days you don't have to we said no you have to get to pay in advance for a whole year and luckily they told me they have a financial product that allows me to take alone so I can pay that and as you can imagine this was a 19 percent right along with the hundred or initiation fee but you're in a bad spot I was in a bad spot that you were to go to Princeton come back the next day it was a spend not name in Boston so I did that and you know of course once the loan I had to get the loan to pay one payment in an eye and repaint it but imagine I was close to the edge here I was I lost a day of work train tickets $500 increase in insurance premium and I took this bad loan on top of them now if I was close to not making it right now so she really ought to push me over the edge now where would the money come from right if I didn't have some money put aside and and this is what we're doing you know we were creating a financial system that penalizes the poor how do you think we have free checking that's right it's not over drought it's all right it's the poor suckers who don't have enough money and charge on their ATM and pay $35 a pop for over a drafting I think the last study I read said that 4 percent of the banked pay 40% of the overdraft fee's yeah it wouldn't surprise me I mean and you know and with credit card and fees it it's probably more and and the whole problem is the temptation of free so so we have banks and they say free checking and we all get so excited and we rather these banks to open accounts but they're not really offering free checking they just need get the money somewhere else and it's getting by saying if you made a mistake will charge you a huge penalty for that and I think that's just something we need to cancel we need to stop this abuse and it's going to be very hard because we the people who are paying now we'll have to not pay now for services we'll have to agree that we'll start paying for services but we'll dramatically cut down the subsidies we're getting from the poor so what do you think it's more effective when somebody is getting out of debt they they enter into a repayment program and so they're going to make monthly payments to get out of debt is it more effective at that point to teach them the envelope method or to teach them why they were spending in the first place to give them awareness so so I think the envelope method is probably more effective because that when you teach people questions about why the issue is will they use it every time and you don't need to fail a lot to fell enough to devastate yourself so think about something else like texting and driving if you know the principle you might do it less but if you do it even once you can kill yourself for other people and and in the envelope method kind of is it's always going to be there with you and if you do it it's always there with you whether you think about it or not what it's thinking you know it's hard to assume that people who think about it all the time people have other things to worry about and the truth is that not everybody needs to become a financial expert so we want finance to be smooth and easy and we want people to have plans and then to have some way to execute it but we don't want everybody to become a financial wizard and every time you say oh is this worth it is this not is this we want it not to be a big part in the same way that we don't want people to be doctors we don't want to think all the time about what decisions they have everybody needs to worry about the part of the life that they are specializing it or become experts you know who that and so on so I think we need to automate systems that just make it easy maybe not perfect but with less opportunities for big mistake let me give you an example right now there's a group of guys that I know who are developing a financial that will automatically monitor your credit cards and your bank account and tell you how much money you have left over each month and automatically put in place a plan to dig you out of debt that sounds like it meets all of your criteria that's right that's right I think that's exactly what you mean it's something that doesn't require lots of thoughts and effort even though it makes decisions for you even though it's so so you know there's always a question about paternalism do we tell people what to do and I think the reality is that we should but we need to now somebody can always not do it I mean we don't force them when to do it and but I think we do need to be more heavy-handed we need to understand that these are really tough decisions people are facing a marketplace that tempts them it's incredibly complex and I don't think we should be hesitant about being heavy handed in terms of game giving people the recommendation I think having handedness is where the value is going to be in the same way that you want to go to the doctor you want them to tell you what they really believe you should be doing what is that the people want or need to hear from a trusted adviser for them to take action to get out of debt do they need to hear specific advice this you were saying we kind of need a fraternal influence yeah so if you think that people could do by themselves the trade-off between now and later it's just angled to happen mm-hmm what you need to do is to break it into components and saying I think we need to give people two sets of advice we need to say this is the minimum amount that you need to do you can't do less than that and here's what I recommend to do the fact is that all of those whether it's the minimum amount you need to do to get into that other you know group in X years or what I recommend you to do to get out of that sooner we cried tremendous sacrifices and the question is if you're the expert should I listen to you that these are the rights sacrifices and and and not all sacrifice are worth more are making right and I think that's what that's what the experts really need to understand their clients and so let's just think about something simple and you drink coffee you have a smartphone and you have cable which one of those should you cut it's very easy to say cut all three of them but maybe one of them gives you tremendous joy in life coffee smartphone TV whatever it is what we need to do is to figure out how much should we cut for what kind of benefit and and I think that's what the financial advisors really need to do to get into the mind of the person to understand the utility function and their preferences and make suggestions that are compatible with this because you know you don't want a life in which you're miserable your whole life and then you die very wealthy or you can start spending when you're 70 the reality is that life is about trade-off between now and later and we need somebody to help us make more thoughtful deliberate accurate and trade-off the tree would maximize the quality of our life so if you if you called me and you said Steve here's my situation is it more effective for me to try to sell you a solution or tell you the solution so so I think it's it's telling but I think it's telling after you have learned something about me right so if you could say okay so let's think about your life and let's think about what gives you joy and let's see where you're spending and let's think about how would you cut spending in a way that doesn't take too much of your joy out let's think also about your long-term plans I think that would be a better but I think that listening first is an important component so what are your goals and how can I help you achieve them what are you goals what are you enjoying what are you suffering from what are your issues and that's within that try to optimize okay all right well thank you so much for your time I appreciate it this has been a get out of debt production in the event of a debt emergency walk do not run to the nearest computer

Channel: Steve Rhode

Views: 9,069

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Keywords: behavioral economics, dan ariely, steve rhode

Id: dVNlgMWLYbc

Length: 37min 30sec (2250 seconds)

Published: Wed Jan 30 2013