are not irrationally high. Those who believe in the efficient markets
hypothesis claim that stock prices are always correct. The conventional
wisdom is based on the assumption that markets are rational, thus stock
prices cannot be too high. If markets are crazy, however, the best invest-
ments might be radically different from those suggested by the conven-
Thus, in order to decide where to invest our money, we must first eval-
uate the idea that markets are rational. We do this in two parts. In Chap-
ter 2, we ask whether people are rational, and in Chapter 3 we ask
whether groups of individuals interacting in financial markets are ratio-
nal. We will conclude people are not rational, and markets are often
In this section we meet the lizard brainā”that part of our financial
decision-making machinery that costs us money. We will find that we are
built with a backward-looking, pattern-seeking brain that tends to make
us want to buy when prices are irrationally high and sell when prices are
irrationally low. We are built to be exactly out of sync with financial
Lizard Brains and the
New Science of Irrationality
Do Not Be Afraid to Meet the Lizard Brain
āā˜Boy, the food at this place is really terribleā™ . . . ā˜Yeah, I know, and such
small portions.ā™ Well, thatā™s essentially how I feel about life. Full of lone-
liness and misery and suffering and unhappiness, and itā™s all over much
too quickly.ā So says Woody Allen in the role of Alvy in the opening
scene of Annie Hall.
Similarly, our rational skills for finance are simply terrible, filled with
systematic errors and biases. As with Woody Allenā™s punch line about not
getting enough bad food, we use our limited analytic skills far too rarely
when we make financial decisions. As bad as we can be at making finan-
cial decisions with the more rational parts of our brains, we get in even
more trouble when the lizard brain starts calling the shots.
In this book, I divide the human brain into two parts: the prefrontal
cortex and the lizard brain. This is a dramatic simplification of an
extremely complicated reality. Most, but not all, of what we think of as
12 The New Science of Irrationality
abstract cognition occurs in the human brainā™s prefrontal cortex. The
term ālizard brainā includes many important human brain regions that
have nothing to do with reptiles.1
Thus, ālizard brainā is shorthand for an important idea. It is used in the
spirit advocated by Sir Peter Medewar, a scientific expert in the study of
aging, in his famous article, āAn Unsolved Problem of Biologyā:
Being in some degree crippled by the handicap of trying to be intel-
ligible, I am bound to make statements which, if not baldly wrong,
are true only with qualifications which I shall have not time to give
them. This disability is not to be avoided; one gets nowhere if every
sentence is to be qualified and refined.2
Similarly the lizard brain is a term that I grew to use while conducting
research with my Harvard Business School colleague Professor George
Baker. I continue to find it productive even in discussions with experts in
behavior and cognition. Because the reality is complicated, however, we
must remember that ālizard brainā is verbal shorthand for the less cogni-
tive, less abstract, mental forces that influence human behavior, most of
which have nothing to do with lizards.
The lizard brain is great for finding food and shelter, but terrible at
navigating financial markets. Many financial problems occur when we
use the lizard brain to make monetary decisions. Instead of using the ana-
lytical part of our brain, we often default to older parts of our brain that
helped our human ancestors survive for tens of thousands of years before
financial markets were created. The lizard brain is not stupid, but when
confronted with problems never experienced by our ancestors it can
make us look crazy and cost us money.
Before we investigate how the lizard brain leads us astray in financial
matters, we must first deal with another human universal: Criticism is
unpleasant. Being told that we are bad at something is, for most people,
about as enjoyable as a mild electric shock. As a professor, I see this with
my MBA students on a daily basis. At the Harvard Business School we
follow the Socratic method and an integral part of that technique is getting
Crazy People 13
students to reveal their own logical errors. This approach is an effective
way to teach, but one that can be painful for the student as they learn the
limits of their knowledge.
As we embark on learning about the science of irrationality, the
unpleasant message is that all humans are built to make certain sorts of
mistakes. Itā™s all fun and games until the irrationality comes home to
roost in our own brains. Then rather than learn, our instincts direct us to
close the eyes, cover the ears, and deny the truth that we, too, are irra-
tional. In all the oral stories of Homer, the only known reference to writ-
ing comes in the form of a secret message. It is in the Iliad, when Queen
Antea falls in love with handsome Bellerophon who spurns her love.
Enraged, Queen Antea convinces her husband, King Proteus, to kill
Bellerophon (Antea does not reveal her secret and adulterous love).
Proteus wants to kill Bellerophon, but shies away from doing the dirty
work himself. Instead he has Bellerophon travel to another kingdom,
bearing a secret message for the ruler of the neighboring land. The con-
tent of the secret note is ākill the messenger.ā So, one of the first men-
tions of writing reveals a human tendency to kill the messenger.
The reward, however, for not killing the messenger and critiquing
oneā™s own behavior can be large. After the 1997 Masters golf champi-
onship, Tiger Woods reevaluated his game. In the Masters, he had domi-
nated the field and won by a record 12 strokes. Furthermore, in less than
one year on the professional tour, Tiger won four events, earned over a
million dollars, and became a worldwide celebrity.
After this initial round of fame and success, what was Tigerā™s view of
his game? He decided that he needed to fundamentally change his swing.
In an interview with Time magazine (August 14, 2000), looking back on
the decision, he told writer Dan Goodgame:
I knew I wasnā™t in the greatest positions in my swing at the 
Masters. But my timing was great, so I got away with it. And I made
almost every putt. You can have a wonderful week like that even
when your swing isnā™t sound. But can you still contend in tourna-
ments with that swing when your timing isnā™t as good? Will it hold
14 The New Science of Irrationality
up over a long period of time? The answer to those questions, with
the swing I had, was no. And I wanted to change that.
Tiger went back to the drawing board. He revamped his swing, suf-
fered through some disappointments, but ultimately emerged as the dom-
inant player in the game. At one point, Woodsā™ lead over the second-ranked
player was larger than the gap between No. 2 and No. 100.3 He went from
being a great player to perhaps the greatest player of all time. The lesson
is clear: Winning requires critical self-examination. If Tigerā™s game
needed improvement and benefited from some objective review, the rest
of us surely can profit from honing our investment skills.
The Science of Individual Irrationality
The debate about irrationality has two components. First, do individuals
make good decisions? Second, are market prices correct? While there is
still a debate about the efficiency of market prices (weā™ll cover this topic
in the next chapter), the first question has been answered. Over the last 30
years, a significant body of research has clearly illustrated our human
In the late 1970s, Professors Daniel Kahneman and Amos Tversky
began the rigorous documentation of human decision-making problems.
One of Kahneman and Tverskyā™s famous experiments concerns the hypo-
thetical woman named Linda. Hereā™s what they asked in the experiment:4
Linda is 31 years old, single, outspoken, and very bright. She
majored in philosophy. As a student she was deeply concerned with
issues of discrimination and social justice, and also participated in
Which of these two alternatives is more probable?
1. Linda is a bank teller.
2. Linda is a bank teller and is active in the feminist movement.
Crazy People 15
Take a moment to answer the question (weā™ll get to the correct answer
shortly). First, know that most people provide the wrong answer, and
there is an intellectual debate over how to interpret the errors. Old-school
economists have said that the errors were caused by poor experimental
design. Their first response was to deny the evidence that humans make
the mistakes shown by behavioral economists.
Behavioral economists refined their techniques and provided proof
that people make mistakes in many important areas, going far beyond the
Linda problem. Mainstream economists no longer refute this evidence,
but still insist that models of robotic, cool-headed decision making are
appropriate. In contrast, behavioral economists believe that conventional
theories about rational behavior need to be fundamentally revised.
Back to Linda. What was your answer? The correct answer is: Linda is
a bank teller. Of all the bank tellers in the world, only some of them are
active in the feminist movement. This is true for any two attributes. Con-
sider 100 college athletes. How many of them are women? How many
are women and over 6 feet tall? Without knowing anything about the
group of 100, the number of tall women cannot exceed the number of
women. Similarly, there have to be more bank tellers than there are bank
tellers who are also feminists.
People who answer number two in the Linda-the-bank-teller problem
suffer from what Kahneman and Tversky label the āconjunction fallacyā:
The conjoined probability of two statements must be lower than for
either of the individual statements. Of the people in Kahneman and Tver-
skyā™s experiments, 85% gave the wrong answer. Why do we do so poorly
on such simple tests?
Rocket Scientists Who Canā™t Figure
Part of the cause of our individual irrationality is that we arenā™t very good
at doing calculations.
In one of my Harvard Business School classes we investigate the
causes behind corporate waste. We examine situations in which executives
16 The New Science of Irrationality
use corporate funds to pay for individual perks. One of the most famous
and well documented of these is RJR Nabisco in the early 1980s. As
chronicled in Barbarians at the Gate, the CEO of that time, Mr. Ross
Johnson, used corporate money to host lavish parties, hang out with
celebrities, and build an āair forceā of expensive private jets.5
One cause of these excesses was the fact that neither Mr. Johnson, nor
his board of directors, had much stake in the company stock. In fact, Mr.
Johnson owned 0.05% of the company stock, and this represented a small
part of his total wealth. At a key point in my class, I ask my students to
calculate Mr. Johnsonā™s share of the $21 million purchase price of one jet
in the RJR air force. So, what is 0.05% of $21 million?
In one such session I picked a studentā”who had not volunteeredā”to
provide the figure. He reached over for his calculator. I said, āExcuse me,
but donā™t you have two degrees from MIT?ā He said yes. āAnd arenā™t
those degrees in course six (electrical engineering and computer sci-
ence), one of the toughest and most mathematical areas of MIT?ā āYes,ā
he answered. āAnd you still need a calculator for this simple calcula-
tion?ā The student said that yes he did need a calculator.
Most people, even those with analytical abilities sufficient to excel at
MIT, are not good at even basic calculations. The calculator can readily
provide the figure for Ross Johnsonā™s $10,500 (0.05% of $21 million)
contribution to RJRā™s jet fleet. For other problems that our brains do not
solve well, however, the solution is not so simple. Consider the following
two problems taken from the book Mean Genes, which I coauthored with
my friend, Professor Jay Phelan of UCLA.6
Puzzle 1. Chinese families place a high value on sons, yet the Chinese
government exerts extreme pressure to limit family size. Letā™s assume
that the chance of having a girl is exactly 50%, but every couple stops
having babies once they have a son. So some families have one son, some
have an older daughter and a son, some two older daughters and a son,
and so on. In this scenario, what percentage of Chinese babies will be
Puzzle 2. Imagine that you are a doctor and one of your patients asks
Crazy People 17
to take an HIV test. You assure her that the test is unnecessary as only one
woman out of a thousand with her age and sexual history is infected. She
insists, and sadly the test result indicates viral infection. If the HIV test is
95% accurate, what is the chance that your patient is actually sick?
As with Linda the bank teller, almost everyone gets these two prob-
lems wrong, and I could pose many other brainteasers that would also
trip up most people.
In fact, when doctors and staff at the Harvard Medical School were
asked the question about the HIV test, the most common answer they
gave was a 95% chance that the patient was sick.7 The correct answer is
under 2%. Similarly, as long as the chance of having a baby girl in each
pregnancy is exactly 50%, the population will also have 50% girls. This
is true regardless of any rule on when to stop having babies. If you are
interested in detailed analysis of these sorts of problems, I suggest that
you read the risk chapter of Mean Genes. The key message for this book
is that most people have trouble doing mathematical calculations.
Sound investing is based on mathematical analysis that is far more
complicated than the problems we just discussed. At the core of every
investment is a set of costs and benefits that need to be predicted over
many years and in many scenarios. Coming up with the correct price for
IBM stock or for our own house involves some serious math!
All of us who get even simple problems wrong are in good company.
Not only do Harvard doctors make huge mistakes on these problems, so
do the most sophisticated people in the world. One of my buddies, Chris,
has both undergraduate and doctoral degrees from MIT in physics. His
research on lasers is so secretive that he cannot reveal the sponsor of his
work. In other words, he is a twenty-first century rocket scientist (for Val