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From crisis to couch By Haim Handwerker Tags: israel news NEW YORK - When Dan Ariely was 18, a serious accident left 70 percent of his body covered in burns, evidence of which can still be seen on his face and body. Afterward, he had trouble moving his hands, and so he looked for a profession that would not require much writing; academia seemed like a promising option. Today, Ariely, who was born in the United States but grew up in Israel, is a professor of behavioral economics at Duke University in North Carolina, and a respected, well-known figure in American academia. His first book, "Predictably Irrational," published in the U.S. last year, was translated into 24 languages (the Hebrew version is forthcoming) and has sold some 300,000 copies worldwide. The book, which examines the place of economics in our everyday lives, describes how irrational our behavior can be and explains how this can be overcome. There is also a much-discussed article Ariely published two months ago in the New York Times' opinion section, where he asserted that the fat bonuses handed out to Wall Street executives can in some cases lead people to perform less well. Compensation, he argued, is a complex issue, and reality has shown that there isn't necessarily a positive correlation between hefty bonuses and better work. Advertisement Ariely and his colleagues ran several experiments, among everyday people in India and among American students, in which participants were given a cognitive challenge - such as a memory game or a puzzle - as well as technical tasks requiring little thought, such as fast-paced typing. The researchers promised participants bonuses of varying sizes for good performance. They discovered that when it came to the cognitive tasks, which demanded mental effort, participants who were offered the largest bonuses performed less well than those in the two other groups, which were promised smaller ones. When the task was a purely mechanical one, however, the financial incentive did prove effective. The researchers concluded that when it comes to cognitive challenges, the promise of a reward does motivate people to carry out assignments well, but also creates pressure that can hurt performance. Therefore, they claimed, if the studies indeed reflect reality, larger bonuses constitute not only a sizable expense for employers, but also prevent employees from performing at an optimal level. We meet in a cafe in Greenwich Village. Everyone is talking about Bernard Madoff's scam, and Ariely offers his own take on it. "We don't know much about the circumstances under which Madoff did what he did," he says. "Everything we know is based on speculation. We can assume he did not start out as a crook. It's more likely that he had a successful business and made money. At some point he started losing money. In situations like that people think about the short term. He wanted to get through the next quarter, nothing more. So he started to cheat, in the hope it would work, but it didn't and he couldn't cover the losses. He decided to take another chance the next quarter. And so he got in deeper and deeper. "It's something you see a lot among investment managers. Imagine that you are at the stock exchange at 3 P.M., and trading will end at 4 P.M. You've lost money, and you don't want to admit it. So you say to yourself, 'I'll take a small risk and see what happens.' You want to make a profit so badly you don't think about the final outcome and all the trouble you might get into. When you are already in deep trouble, you take bigger risks, and finally it all blows up." Why do people - intelligent people especially - hand their money over to investment managers without checking their investment methodology, as happened with Madoff? Ariely: "Today's investment market is highly complex and complicated. You can't expect ordinary people, even intelligent ones, to understand the complex investments being made. Experts are hard to find ... Also, people traded in their judgment for blind faith in the market. I've spoken to financial experts on Wall Street and asked them how they arrived at this or that share price. The explanation is that the market is efficient. That's what happened here: Blind faith in the market replaced judgment. And this was very convenient." How does this blind faith manifest itself? "People have stopped thinking about multiples and other variables that were used for many years. Those who made conservative estimates were proved wrong, because the market kept rising, over 10-15 years. Those who entered the field a decade ago learned over and over again that this faith in the market's power and rightness was the norm. "In addition, using models to set prices for shares and commodities became very common. The models were created by academics from top universities, and if you get a model from the Massachusetts Institute of Technology, why shouldn't it be good? I called students of mine who work on Wall Street, and they admitted that no one really understands the formulas." So you don't think highly of money managers. "If you told me that the IQ of investment managers is in the top one one-thousandth, I'd say we should consider what they have to say. But I've met many smart people in my life, and I would not say bankers are smarter than others. They've only created such an image for themselves." President Barack Obama will have no choice but to impose stricter regulation on the U.S. financial market, says Ariely: "The lack of regulation was rooted in a profound faith in the market's powers. The belief was that we are dealing with smart people - fund managers who know what they are doing. The problem is that reality does not actually work that way, and I don't think the trust can be easily restored. We'll need to build it through regulation. "The role of regulation is to protect us from ourselves. Would you trust people to resist temptation if they sat in a room filled with the smell of baked goods? People are not very good at overcoming temptation. It's true of chocolate, and it's true of investments." 'Something ignited and exploded' Dan Ariely, 41, married and the father of two, was born in New York while his father was completing a degree in business at Columbia University. When he was 3, the family returned to Israel, first living in Ramat Gan and later in Ramat Hasharon. His mother was a parole officer. His grandfather was Ariel Ariely, former director of the state revenue administration. The accident happened when he was a high-school senior. Ariely was active in the Hanoar Haoved Vehalomed movement, and he and his friends were constructing "fire signs" (from wooden poles and rags shaped into letters that are set on fire). Hoping for a more impressive effect, they decided to use magnesium. "While we were preparing it, something ignited and exploded, and there was a big fire," he explains. "I spent three years in hospitals, at first continuously and then in and out. I suffered third-degree burns, and at some point I got hepatitis from one of the blood transfusions and had to undergo liver treatments." Ariely was a physics and mathematics major at Tel Aviv University, but discovered that this involved a lot of writing, which strained his hands, and transferred to philosophy. When his mother went to enroll him, at his request, she was told he would need another major; it was decided he would study psychology, which made him angry. "I'd had enough Freudian psychologists around while I was hospitalized at Tel Hashomer, and thought this was the last thing I needed," he says. "But I was lucky, and one of the courses I took was in physiological psychology, which focuses on how different parts of the brain function. The lecturer was Hanan Frenk, and he drew me into the field." Frenk had also suffered a grave injury: He lost both his legs during the War of Attrition. The two found common ground. "We spoke a lot about pain, and discovered that neither of us wanted anesthetic when we went to the dentist," Ariely recalls. "After this discovery, we conducted an experiment at Beit Halohem [a rehabilitation center for soldiers] and found that people who had been severely injured were less troubled by [other] pain. I really liked the scientific process. After one year of studies, I decided psychology was my field." Ariely later completed a Ph.D. in cognitive psychology and, at some point, met Prof. Daniel Kahneman, who would eventually win the Nobel Prize; together, Kahneman and Amos Tversky created the field of behavioral economics. Subsequently, Ariely decided to conduct research that involved both psychology and economics, and completed a Ph.D. in business administration at Duke. After a stint as a researcher at MIT and at the Federal Reserve in Boston, he returned to Duke last summer. He still lectures occasionally at the Hebrew University and Tel Aviv University. Conflicting interests Ariely is not surprised about the crazy bonuses Wall Street executives awarded themselves. "They've been out of touch with reality for many years. I don't think these people are necessarily bad, but they have gotten used to a very specific way of life. For many, many years they believed what they were doing was just fine. As long as the economy flourished, it worked. "But now the world is changing, and they've simply forgotten to update the way they behave. When one member of a club gives himself an insane bonus, the others think they deserve it, too. And when you see everyone around you acting this way, of course it reinforces the inappropriate behavior. They convinced one another that they deserved this money. "People have many mechanisms for distorting reality. You sell mortgage-backed securities and receive a $15-million salary package for it. Why shouldn't you convince yourself that it's a good product? I would." Ariely is also critical of the U.S. government for the way it has responded to the crisis, specifically the huge sums it has made available to banks and other financial firms at risk: "When so much money is involved, you have to impose limits on people. They simply handed money over to them, without even requiring that the money be given as loans to the public, although that was the original plan. "I don't want to justify their behavior, which is clearly abominable. But I do try to understand what happened to them. I don't think they are thieves, but they proved once again that people see the world in a way that they find convenient. Suppose you are the head of an investment house that received $50 billion from the government. Why would it seem wrong to take $100 million as bonuses? It's only a small fraction of the sum you received. That's part of how the human mind works. People make up stories to justify their behavior and actions." This is also why Ariely believes that Obama's plan to limit the salaries of top executives at the companies that received government funds, to $500,000 a year plus stock options, will not work. "Over the years, these people have come up with all kinds of reasons for why this is the least they deserve for their abilities and efforts. How many people will actually admit they are paid more than they are worth? "Obama's salary limit proposal seems insulting and irresponsible to these people, compared to what they are used to. My guess is that they won't agree to these terms - if they do, they will come up with tricks for paying themselves what they consider an appropriate, fair wage - that is, whatever they made before." According to Ariely, one of the fundamental problems plaguing Wall Street is the conflict of interest within America's finance industry. "No one would conceive of giving a trial judge a percentage of the damages he awards the plaintiff in a case," he says, "but Wall Street bankers do something of this sort, and they are trapped inside their conflicting interests. "Over the years, financial instruments such as derivatives were invented, and most Wall Street professionals understand nothing about them. Wall Street employees received incentives, and so they told investors these instruments were not dangerous, or described them as low-risk and high-yield. They weren't trying to con anyone - they simply rationalized the things that served them well. When we move away from real money, it's easier to cheat: When we deal with sophisticated financial tools or derivatives, it's easy to cheat, because there's no money involved." But there is yet another set of conflicting interests in which Wall Street is implicated, Ariely claims: Stock trading is often more lucrative for traders than it is for their clients. "A broker makes money buying and selling stock shares," he explains. "The client has to pay for it. It's a very common phenomenon. The market makers in stocks and commodities are also tainted by a conflict of interests. As middlemen, they have some idea about how much people are willing to pay for shares and what they are willing to sell them for. That way they can create deals that will put a large profit in their own pockets." What's the solution? "To identify these conflicts and eliminate them, like they did some years ago with analysts who wrote positive reports on the companies their own investment houses took public. The analysts used to get bonuses for these deals. When the Internet bubble burst, there was a decision to put an end to this, and analysts no longer get bonuses for public offerings. The problem is that Wall Street did not continue this process of elimination." Bookmark to del.icio.us   Ivrit in Iraq Iraqi professor asks Israel for shipment of Hebrew books. Racist reality show Reality show contestant calls his shoe 'Mohammed', angering Israel's Arabs.

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