[REPLAY] Dan Ariely – The Human Capital Factor (Capital Allocators, EP.195)

0:05Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can keep up to date by visiting CapitalAllocators .com. My guest on today's show is Dan Ariely, a leading behavioral economist, author, entrepreneur, and the James B. Duke Professor of Psychology and Behavioral Economics at Duke University. Dan is also a founding partner of Irrational Capital, an investment research firm that quantifies the impact of corporate culture and employee motivation on financial performance.

0:57My initial conversation with Dan two years ago has been one of the most downloaded episodes of the show, and a recent research piece by J .P. Morgan, entitled The Human Capital Factor, that highlights his work, got me excited to catch up with him again. Our conversation covers many aspects of his continuing research to identify positive human capital practices and performance in the workplace, including data collection and assessment, gender differences, goodwill, ESG, and changes during COVID. We then turn to the practical application of the research in the capital markets through two indexes and customized research.

1:39We close by talking about Dan's new research project and some of his favorite recent answers to his Ask Ariely column in the Wall Street Journal. Please enjoy my conversation with Dan Ariely. Dan, great to see you. Lovely to see you too. It's been a long time. It's been a little while. And I would love to start with when you first came on the show, we talked a bunch about your research and some of those incredible stories and insights. And then we also started talking about what was the beginning formation of a rational capital and this model you had built. So what's happened in the last couple of years with the business and the model?

2:23So first of all, just kind of to remind all of us, we started on this journey about four years ago to try and quantify human capital. And it started from my basic research on human motivation, and we moved toward understanding how companies treat their employees, how employees feel about the company, and what impact this has on the performance of the company in the stock market. And we had some really good, interesting results, suggesting that it's a really wonderful place to look for excess returns. And when we talked last, we found all kinds of interesting things that fit with social science, right?

3:00So we found that overall level of compensation doesn't matter so much. fairness, perception of fairness in compensation matters a lot. So we found lots of these nuggets. And the argument was that it would be incredibly important to invest based on that. How could you not? And one of the things that puzzles me is that if you gave people that information, how many people would say, oh, yes, I want to ignore this. I don't think that human capital is important. I don't think employee motivation is important. Of course, it has to be crucial. Since then, we've done a couple of things. We've expanded our data.

3:40One, we did a huge study during COVID to understand what's going on during COVID. We try to understand what does this have to do with ESG. And we try to look at it in terms of gender issues. And we're even more confident now that this is a good signal and a very good strategy for investment. So those are the top lessons. Great. Well, let's go through each one. So let's just start with data. What's evolved in the discovery of these data sets and how you've accessed them? So we started with a proprietary data set. And that was what we did our initial analysis on. This was a data set that gave us information on companies from 2006.

4:28And we also started looking at other sources of data. Think about things like including a glass door in terms of all kinds of things. And the thing about it, if you look at something like glass door and you don't know where to look at, you're not going to find much. But with our proprietary data, we basically knew what to look for. So we could find some interesting things there as well. And then thankfully, we got another really amazing data partner that gave us a tremendous amount of new data to look at. And what's really good about this new data provider is that this data provider is not just interested in giving data, he's interested in figuring out over time what other questions we might want to ask.

5:19So if you think about these employee surveys that companies do, what would you ask if you were interested in financial returns? So we can ask, of course, questions like, how happy are you with your salary? Or how fair is promotion in this place? So we can ask about psychological safety and so on. But we could ask all kinds of new questions. So we're basically started a new era in which we're not just consuming existing data, but we can also explore new opportunities. And that has increased the value of what we're doing. Is that main methodology through surveys? Yes. So our main methodology is through surveys.

6:01And I know that it's a really interesting question of, is this the right method? So let's look at something like pain. It turns out that when you look at pain, there's no better methodology than to ask people, how much pain are you feeling? We can't measure your neural activity and infer from it correctly how much pain you feel because it's such a subjective experience and we don't understand how to record it. We don't know how to record it at the brain level. We don't know how to record it in accuracy at the receptor level. So we end up saying, how much pain do you feel on this scale from no pain at all to a lot of pain?

6:37The same thing is true for other things. And when we ask the question of how excited are you to wake up every morning and go to work, what could we substitute it with? We could substitute it whether you get to work on time, but it's a very noisy signal. Maybe if we could measure the jump in your step as you walk to the office, that would be something useful. But the reality is that a lot of the things that we want are things that are happening inside people's brains. And I wish there was a better way to get this data, but there isn't. And when we don't look at what's happening inside people's brains and we look at other things instead, we're giving up a lot.

7:20So, for example, think about something like sick days. Sick days is obviously a really good indication of how excited people are about work. But it's a very rough indication. For each one individual, you wouldn't know that there's a sick day. If you take a whole company and you look at changes in sick day over years, it would include things like seasonal flu. It would include all kinds of things. It includes some signal about commitment to work. But I sadly still think that the best way to do it is to just ask people. And maybe one other thing about this is that when we ask people with these data providers, it is very important that the data is being collected by a third party.

8:06You know, if the company is trying to collect the data directly from employees, there's always a risk that people are trying to create some impression management within the company. But if it's done on the third party website and the information is going to be only presented in aggregated ways, we have a better chance of getting good data about this. You also mentioned with Glassdoor, which we're all familiar with, you have to kind of know what you're looking for. What's an example of something that you could take the data from something available like that and know what you're looking for? So I'll give you an example.

8:42One of the things we find is that it's not about just the overall level of, let's say, feeling appreciated. So we find that feeling appreciated is a very good signal. But it's not just the overall level of being appreciated. It's the difference between how management and rank and file employees feel about being appreciated. We call this alignment. And companies that the gap between how they treat management and how they treat employee is very large. Our companies are actually less productive in the stock market. because there's a gap. And we mentioned the issue of relativity. Relative pay is more important.

9:27Relative fairness is more important. Fairness is all about relativity. The same thing is true about employees versus management. So if you look at Glassdoor and you want to understand better the information, it is really good to try and separate the role that people have. And if you find that people are complaining equally at management and at the level of the employee. This is not as a bad signal as if management is not complaining and employees are complaining much more. So that's an example for what to look at. As you've looked at all of this research into this collective human capital factor, how have you broken down, I don't know if you'd think of it as a taxonomy or a list of all of these different things that you found can impact stock price performance?

10:18So the things that we find can, there are different types of things that are important. One of the most important one I think of under the category of goodwill. So think about the difference between the minimum of work you have to do to keep your job and the maximum you could do if you're truly excited. And we all have to admit there's a big gap between those two, right? And companies can contract on the minimum amount of work you need to do, but nobody can contract on how much energy you're really putting toward work, how imaginative you're trying to be, how much you're reading extra, thinking hard, and so on.

11:01And that really comes from aligning your own utility function with the organization's utility function. And it means that when your organization does better, you feel like you're doing better as well. You're not separating it. Think about your significant other. You're not saying, oh, every ounce of happiness the other person gets takes away from my ounce of happiness. So every dollar they spend takes away from my dollar. No, it's a joint utility function. We are better off when they're doing better. And that's one of the most important things. So what does it mean? It means that you feel appreciated.

11:41It means you have autonomy. It means the bureaucratic burden is not drowning you. And there's another really interesting aspect there. And it's that you feel that people judge you based on your intentions and not based on the outcome. Every organization wants people to try new things. but if you tell people please try new things figure out how to make things better but if you make a mistake i'll punish you how likely are people to try new things i have the privilege that in addition to irrational capital i also am a professor at duke and i have a research center about 50 people here mostly work on financial decision making and health and i try to get people in the center to take failure seriously.

12:31I try to tell them you should aim for about 50 % of the experiments failing. And what I mean by that is that I want them to take risk. I don't want them to make stupid mistakes, but I want people to take risks because without risk, you know, if you say, let's do improvement at our sure things, they're going to be tiny ones. If you want people to swing for the fences, you need to accept risk. So one bucket of things is about taking on the utility company of the organization. I want the organization to do well. I'm willing to take risk. I'm willing to work extra hard. I feel connected. The utility function is the same.

13:14That will be one important thing. Another important thing is, as we said, fairness. So that's an important aspect. A third one has to do with all voices being heard. And this, by the way, we found one of the things that changed during COVID is what we call inclusive innovation has increased in its importance. Because imagine a group of 10 people around the table, and you have a physical meeting like we used to have back in the day. And you have a physical meeting and everybody participates. And of course, there'll be some people who participate a lot and some people don't participate that much.

13:58The moment you move to a digital platform like Zoom, the people who don't participate can have zero participation. So, and all of a sudden, important voices around the table get to be completely ignored. Some companies are worse at this. They allow more of this to happen, and some companies are better at that. So in general, those would be the main factor. Utility function, low bureaucracy, autonomy, feeling that mistakes are acceptable and risk is encouraged, giving everybody a voice in the company in fairness. Those would be the big buckets. And there are scores of things that are connected to many of them, like psychological safety ends up being very important, but it connects to a lot of those.

14:50I'm curious about some of the inputs that go into some of those outputs. So some of these things, psychological safety is part of the process, how someone is producing almost as a function of an output. But how do you think about, say, the impact of leadership, the style of management, and things like that as it relates to these human capital factors? Before we go there, I want to say something about gender, because it's not just about gender. It's also about the measurement issue. So in the US, there's an index called the SHE Index. What they do is, and it's a very nice idea. they go and they count what is the percentage of women on the board and what is the percentage of women in high positions in the company.

15:42And if you think about it, what you really want to know is how do women feel in that company? But it's hard to measure how women feel in that company. So what do they measure instead? Something that is easy, like what percentage of women are on the board and in high positions in the company. Now, let me ask you, what would you predict? How well does this index does compare to the S &P 500, for example, the last four years? Maybe a little bit better, but it's so easy to lose signal and noise in that type of metric. Yeah. So it does much worse. Systematically, repeatedly by big gap. Now, is that because it's a good idea to mistreat women?

16:29Of course not. When we look at our data and we ask the question of what is the gap? We said a lot of things are about relativity. So we said for each company, let's calculate the gap between how men feel and how women feel. Like, you know, do you feel appreciated? What's the gap? And so on. And that index gives about 5 % over the S &P per year. What is the index? Is it the narrowness of the gap leads to outperformance? We take the 20 % companies who have the narrowest gap between men and women. And we said, what if we invested in those 20 %? Imagine you take the S &P and you say, let's take all the companies in the S &P we have data for, and we will take the 20 % companies that the gap between men and women is the lowest.

17:26now it's there are very few companies where the gap is zero but that creates a real substantial return now how do you deal with these two seemingly opposing facts you look at our approach we find big returns to treating women well you look at the she index it looks like a negative effect what's the truth here how do you look at it and it turns out that and this is really important that often we measure what's easy in terms of what's important. And if you think about the SHE index, nobody, nobody in their right mind would think that if you assign more women to the board, that by itself would change a company.

18:12It's a perfectly great first step, but it wouldn't change the company. What people think is that this would lead to more equality of women down the line. but it turns out that if you have a check the box approach, it doesn't because you stop at that. So I want to make two points. The first one is that we need to measure what we really want to measure. And when we create proxies to remember that we make this assumption. So we say, okay, we're measuring women at the board and at top level. What do we think? We think that their existence will basically change the way women feel across the company.

18:54It's an assumption, untested, but if it doesn't, that index will not work. And the second thing we need to remember is that when we measure easy things, we can create a check -the -box approach to companies rather than trying to get them to really deal with the problem. And we found a little bit of that. We found that some companies, when they assign women to high positions, the women within these companies feel worse. Why? Because they take it as an indication that the company doesn't really care about them, that they're only doing things to appeal to PR, like window dressing. And as a consequence, they feel even less cared about and so on.

19:43So one is we need to figure out what we really want to measure and to measure it as directly as possible. And the second, we need to recognize that when we move to systems that have the check -the -box approach, people might be able to do the check -the -box methodology without dealing with the underlying problem. Are there other examples that were blaring in your research that you saw a common check -the -box approach to get at something that the real data or what you're trying to measure was actually the opposite? Not as bad as the opposite as this index, but I will tell you that if you think about things like better coffee, better tables, better chairs, compared to feeling appreciated, there's just no comparison.

20:37And the thing that happens there is if you get better coffee, and I'm a big fan of coffee, so I love good coffee. If you get better coffee or a better chair, you get used to it. feeling appreciated is something that is almost daily. You don't get used to it in the same way. Or lack of fairness is not something you get used to. That's one thing. And then another one is ESG. Now, in my mind, there are two reasons to do ESG. The first one is the moral thing to do. You're saying let's have less reliance on energy. It's the moral thing to do. But there are lots of discussions out there about ESG being a profitable strategy.

21:25And that's a different story, right? Saying the moral thing to do, that's great. But when you say it's a profitable strategy, here's a place where I lose people a little bit. Because if people say it's a profitable strategy, I want them to tell me how. Like, what's the pathway from ESG to being profitable? And I can see three ways. One is reducing cost. You're saying, well, we're going to become ESG. We're going to start considering other things that we didn't think about before, maybe less plastic, maybe this will become more efficient and we'll reduce costs. That's one possibility. I think it's a relatively small one, but it's a possibility.

22:06Another one is you'll say, well, we will come up with more creative ways of doing things in the future. We'll figure out better efficiency. But I think that the real pathway for ESG goes through employee motivation. If you think about it, the moment you are doing some version of ESG, presumably your employees are more on board. They feel that the company has better goals, the company is more connected to the future, taking care of their kids, all kinds of good things that come through employee motivation. But when companies do ESG, I don't think they really think about the pathway. I don't think the pathway by which ESG goes and creates profitability.

22:54Now, the moral thing to do, perfectly fine. But what about the profitability part? And we find, if you look at our results, we have like 6 % a year of alpha of treating your employees well does better. That's a direct path. and with the ESG I see a lot of companies go through the check the box approach again doing something mechanical rather than thinking about what's the underlying mechanism that goes here a company is like a complex machine and you want to ask like what is the energy that runs this machine and how do you get more of it and how do you get it to be you know better running machine.

23:38So I think ESG, which I think is incredibly important, people are doing it without deeply thinking about what it really means and more with too much of the check the box approach. And I think it's a shame because I think ESG, look, in the same way that the human capital index gives so much return, there could be other opportunities out there. But people are not really thinking carefully enough about the mechanism, and that's a shame. I'm curious how you think about the application of the research that you found. So on the one hand, rational capital, there's now a human capital index that you created, and you've shown that it's outperformed.

24:23On the other hand, you have all these insights that companies could deploy to make them much better companies. How have you thought about where you want to make the most impact? So I think about three separate ways. One is we have an index, you can invest, you can give companies who are better to their employees more money. You would also want to make this public. You would make this public so that companies who want to raise more money would say, hey, we're treating our employees better. Give us money in the same way that companies do ESG. Let's double down on that. I also think that companies need to start changing the roles of HR.

25:06HR in most companies is a procedural legal function. They do the sexual misconduct and the module. They worry about procedural things. I think that HR needs to be an R &D function. They need to continuously try different things and improve how the company is running. I don't think there's one recipe for all companies. Everybody wants to be appreciated. People want to feel that they can make honest mistakes. All of this is true. The path to get to those might be different for different companies. And HR needs to be the function that improves things dramatically. So I think one is there's the index.

25:50Two is I want companies to start carrying, elevating the role of HR. And the last thing is that I'm hoping that people who want to invest seriously in a company would do their homework, including homework on human capital before they invest. So let's say you have an activist investor. They want to buy a percentage of a company and to start influencing it. What homework do they do and how much is their homework influenced by human capital? Probably not that much now, but I hope that they would. And I think that a lot of investors, a lot of activist investors, look at companies where they don't like the culture and they say, let me buy that company and influence the culture.

26:35But I don't think they systematically understand the culture. And what we have created is a systematic way to understand the culture as it refers to potential success in the stock market. So it's not everything, but it's a lot of very important elements. So if we break that down a little bit, you've now productized this index, it sounds like. So we have two indices. We have one index that is general about human capital. And we have another index, which is about the gender equality. And both of those are doing, in general, very well. You can ask the question of, like, what happens during COVID?

27:19Have our factors become less important, more important? And, of course, in the history of the stock market, COVID, it's a short window. But we did a study with about 1 ,400 companies during this period. We took the things that happened in the stock market from March until the end of October. And we looked at our results and we said, are the things that are important in our results in the past still important? And what impact have they led to? And what we found was that everything that we found before became even more important. The companies in general, if I remember correctly, between March and October, the stock market lost a lot and then gained a lot.

28:14And it was about 5 % net overall. The companies that I'll tell you now about went up by 15%. That's a big gap. And those companies worked a lot on appreciation, which we said was incredibly important. They worked on inclusive innovation, how to get everybody around the table to participate, to talk, to give their... And it's companies that the CEO helped employees see the mission of the company. during COVID it was easier to just hunker down and worry about the daily issues but the long -term effect of where the company is going was incredibly important if you take those three components they made a huge gap between the companies who were doing average and the companies who were doing exceptionally well and we found one other thing that they changed from before COVID so So before COVID, we found that employee benefits didn't make a big difference.

29:23Financial benefits, health benefits didn't matter. During COVID, there was actually a positive effect of these benefits. And I think it's because period when people are more worried. People are more worried about what's happening in health, what's happening in retirement, and so on. So those benefits became more important. not more important than feeling appreciated or anything like that, but became from being almost not important or becoming slightly important. Now, I think that will go away, but it was interesting to see how this timing did change a little bit the mix of what was important. So a couple of questions about both the research and the index strategies connected to each other.

30:07So the first is, and maybe COVID is a good example, there was this bifurcation of performance of companies, depending on whether they were technologically savvy versus sort of old economy or in -person type businesses. So how do you think about the differences in these factors across sectors in your research? So we didn't do this research during COVID, but we did, of course, in the pre -COVID data right from 2006 and on. And we found no difference. When you do kind of statistical modeling, there's what's called nested models. So you could say, let me create a model for within each sector, manufacturing, consumer goods, IT, and let me also create a factor across everything.