working as an investment banker. His detailed knowledge of debt-laden
companies had made him a bit gloomy about the economic situation.
After hearing Adamā™s views, I asked where he had invested his money.
Given his dour outlook, I expressed surprise when Adam said he had
60% of his wealth invested in stocks. In response to my shocked look, he
asked for my advice.
Clearly Adam thought he was being conservative with only 60% of his
wealth in stocks. Hasnā™t it been provenā”over hundreds of yearsā”that
stocks provide the greatest long-term return? Shouldnā™t a patient
investor, particularly a young one, put almost everything in stocks?
Maybe. Maybe not. Conventional approaches to answering Adamā™s
question are based on the old-school assumption that people are cool-
headed decision makers and that financial markets are rational. Recently,
a new school has arisen that embraces hot-blooded human emotions as a
core feature of our world. The reality is that financial markets have
always oscillated between manias and panics, but people have not been
terrifically adept at identifying them in advance. The new āscience of
irrationalityā provides a novel way to model the future and offers
investors powerful tools for growing and protecting their wealth.
Moving beyond simply describing financial irrationality, we find an
underlying logic for costly behavior in what I label the ālizard braināā”
an ancient, often unconscious thought process that exerts a powerful
influence on us. This lizard brain has helped us reproduce, find food, and
flourish, but it tends not to work so well when dealing with financial mar-
kets. The result? Mean markets that wreak havoc with our finances.
We will use the new science of irrationality and an understanding of
the lizard brain to evaluate bonds, stocks, and real estate. We will find
that the current situation is almost a perfect storm designed to frustrate
our financial plans, and this will lead to surprising answers to Adamā™s
question. In addition to learning where to invest, we will produce novel
suggestions on how to invest. Beyond simply making more money, a goal
of Mean Markets and Lizard Brains is to increase confidence and reduce
The Conventional Wisdom:
Bonds Are for Wimps
Adam works for a famous Wall Street investment bank. If he were to look
to Wall Street for guidance on where to invest, he would find some sim-
ple advice. Buy stocks. Figure 1.1 shows the consensus of the leading
Wall Street investment firms.
Wall Street says to invest the bulk of our money into stocks. In addi-
tion, economists trumpet the high return on stocks. (āBonds are for
wimpsā is a quotation of Harvard Professor Greg Mankiw, head of Pres-
ident Bushā™s Council of Economic Advisors.1) Those of us who live on
Main Street have heard the ābuy stocksā message loudly and clearly.
FIGURE 1.1 Bonds Are for Wimps (Wall Streetā™s Investment Advice)
Source: Dow Jones Newswires, Wall Street financial strategists2
While only 5.7% of households owned mutual funds near the stock mar-
ket bottom in 1980, the figure now sits near an all-time high of 50%.3
Furthermore, the most recent Federal Reserve Survey of Consumer
Finances reports that stocks represent 56% of all Americansā™ financial
assetsā”a record high.4
So Adamā™s decision to invest most of his money into stocks reflects
both the conventional wisdom and common practice. But should we con-
tinue to buy stocks and confidently expect high rates of return?
Wax On: The Science of Irrationality
In The Karate Kid, Daniel (played by Ralph Macchio) moves to Califor-
nia and earns the hatred of a pack of teenage bullies. In self-defense, he
seeks to learn karate from Mr. Miyagi, the apartment custodian. Daniel is
puzzled, however, when his training consists of performing household
chores. For example, he spends many hours polishing Mr. Miyagiā™s cars
using a particular āwax on, wax offā technique. In a frustrated confronta-
tion with Mr. Miyagi, Daniel is surprised to find that the cleaning tech-
niques are actually karate moves.
Similarly, we answer Adamā™s question by first addressing core prin-
ciples and later applying them to bonds, stocks, and real estate. The
conventional wisdom is based on a view that people are nearly perfect
decision makers. Sane investors, the rational view suggests, would buy
risky stocks only at prices low enough to promise a high return. Thus, the
standard advice to buy stocks is based on the assumption that market
prices are rational. If markets are crazy, however, then the ābuy stocks for
the long runā message might be wrong. To know where to invest, there-
fore, the first step is to investigate rationality.
Are people really cool-headed robots who calmly evaluate financial
opportunities according to the maximizing rules of calculus? There is
one place in the world where people do act this way; that place is eco-
nomic theory. The standard assumption in economics is that people make
such good decisions that our choices are labeled as āoptimal.ā Conven-
tional investment advice is based on this underlying belief that people
and financial markets are rational.
In the real world, however, people are far from rational. Perhaps my
own most poignant lesson came in a battle with a wedding photographer.
After taking the pictures of our wedding, Juli the photographer would not
give us our pictures. I appealed to Juliā™s morality and to her self-interest
with a variety of sophisticated tactics to get our photos. I even offered to
pay additional money. To all these rational tactics, she never responded.
After Juli spent some time in jail, however, she relented and gave us our
negatives. Was her behavior rational? No. She gained nothing from her
obstinacy and suffered severe penalties. Is such irrational behavior com-
People are crazy. While we all know this, the investigation of the eco-
nomic implications of irrationality began in earnest only in the late
1970s. Professor Daniel Kahneman, along with the deceased Professor
Amos Tversky, began the rigorous documentation of human decision-
making errors. In 2002, Professor Kahneman shared the Nobel Prize in
Economics for this new scientific approach to irrationality with my grad-
uate school advisor, Professor Vernon Smith.
Investment advice has not kept up with cutting edge intellectual de-
velopments. While the science of irrationality has grown up, the con-
ventional wisdom still provides investment advice based on outdated
theories of sane people and rational markets.
Wax Off: Meet the Lizard Brain
Behavioral economists have proven that our financial decisions are often
irrational. The obvious question is, why have we been built to be so bad
at such important tasks? To find the underlying rationale for irrational
behavior (which turns out not to be so crazy in some respects), we have
to look beyond standard behavioral approaches to some groundbreaking
work in other fields.
An important source of our troubles lies in the discord between our
modern world and that of our ancestors. We are built to solve ancestral
problems, and sometimes this gets us into trouble. Some of the most
compelling examples of these insights come from medicine.
Consider that babies who breast-feed exclusively need to take vitamin
D supplements or risk serious health consequences.5 Nothing would
seem to be more natural than to feed motherā™s milk to a baby. Why are we
built to cause sickness in our children? The answer is that we (both as
adults and as babies) manufacture vitamin D when we are hit by sunlight.
People who spend a lot of time outdoors, particularly in places with
strong sunlight, make plenty of vitamin D. The babies of our ancestors
got enough outdoor sunlight to be healthy. Many babies (and their moms)
today, however, stay indoors or out of direct sunlight to avoid skin can-
cer, so our natural-born system doesnā™t work. Thus, our babies get sick
because we live differently from our ancestors.
A similar logic is found in the prevention of heart disease. Men, in
particular, are told to take an aspirin a day to thin blood, reducing the risk
of heart attacks.6 Why donā™t we produce blood that has the correct vis-
cosity? The answer is that āthickā blood heals wounds rapidly. Our
ancestors had frequent wounds, and most died too young to worry about
heart disease. Thus, our blood is too thick for us because it is built to pro-
tect us from the ravages of an ancient world where people were often
wounded and died young.
So what does all this have to do with our financial decisions? Our
brains, like our bodies, reflect the world of our ancestors. In particular,
our lizard brains are pattern-seeking, backward-looking systems that
allowed us to forage successfully for food, and repeat successful behaviors.
This system helped our ancestors survive and reproduce, but financial mar-
kets punish such backward-looking decisions. Consequently, our lizard
brains tend to make us buy at market tops and sell at market bottoms.
In Pitch Black, a sci-fi film featuring Vin Diesel, a group of inter-
galactic travelers crash on an ominous planet. They soon learn that the
interior of the planet is filled with vicious creatures. The good news is
that the creatures cannot arise in daylight, and because the planet has
multiple suns, eclipses are many years apart. The bad news is that the
next eclipse, with its consequent destruction, is coming in just a few
Similarly, there is good news and bad news for the role of the lizard
brain in our financial decisions. The good news is that the lizard brainā™s
influence on our financial decisions is only disastrous in some particular
and rare circumstances. The bad news is that we are living in one of those
dangerous environments today. For the last several decades, we have
enjoyed the benefits of several powerful, but unsustainable, financial
trends. Our backward-looking lizard brain is most likely to impoverish us
in precisely these sorts of environments. In a sense, we now face the
meanest of financial markets, almost cruelly set up to frustrate and to cost
Just as we can live longer by understanding the basis of our medical
problems, we can make more money by understanding and taming the
How to Profit from the
New Science of Irrationality
In The Karate Kid, our hero soon stops waxing cars and begins compet-
ing. Similarly, the focus of this book starts with irrationality, but then
quickly applies the lessons to the most important issues facing investorsā”
the health of the economy, budget deficits, productivity, savings, infla-
tion, the trade deficit, bonds, mortgages, stocks, and real estate.
The first section summarizes the key findings of the science of irra-
tionality. We review the evidence that even the smartest of people make
systematic mistakes. These individual quirks create manias and panics,
and markets that are far from rational.
The second section is a primer on the economy, inflation, and the
value of the U.S. dollar. Will U.S. budget deficits hurt the economy? Can
the productivity revolution allow us to be richer and lead better lives?
How will the decline in the U.S. dollar affect investors? When will the
dollar decline end? Is the Federal Reserve creating inflation? Why would
anyone be worried by prices being too low?
In the third section, we apply our analysis to the most important
investment decisions we face. Are interest rates going to rise substan-
tially? Has the bull market in stocks returned, or is the early twenty-first
century stock market rally a trap? Is there a housing bubble?
Our analysis culminates in the final section that provides specific
investment advice. An understanding of the lizard brain provides a time-
less blueprint for effective and low-stress investing. Furthermore, we
reach a timely and unexpected answer to Adamā™s question on where to
The lizard brain will be a leading character throughout our journey.
Are there really $100 bills on the financial sidewalk? The answer is yes,
but they are found in financial blind spots created by the lizard brain. The
new science of irrationality shows us how to see into those blind spots so
we can grab those $100 bills and improve our investment returns with
10 The New Science of Irrationality
he central question of Mean Markets and Lizard Brains is, āWhere
should I invest my money?ā The conventional answer is that those
who seek high returns must take high risk. For a patient investor
with some tolerance for risk, conventional wisdom says to buy stocks.