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Kilmer fans, watch Real Genius to understand this brainy culture). In
spite of all his ability and training, Chris admitted that he got the HIV
problem wrong.
So we aren™t built to do mathematical calculations, and relatively sim-
ple problems trip up MIT rocket scientists. The news gets even worse.
The second big problem we face in investing is that we are systematically
18 The New Science of Irrationality



overconfident. We are bad at doing the calculations required to analyze
investments, and simultaneously we are unaware of our shortcomings.
Our overconfidence comes in many flavors. When people are asked to
rank themselves compared to others, the average rating is always above
average. For example, far more than 50% of people rank themselves in
the top half of driving ability, although that is a statistical impossibility.8
When couples were asked to estimate their contribution to household
work, the combined total routinely exceeded 100%.9
Myriad studies have documented this bias in our self-analysis, but my
favorite remains an old study that asked men to rank themselves accord-
ing to athletic ability. How many men do you think put themselves in the
bottom half of male athletic ability? I suspect that you know the
answer”not a single man who was surveyed reported that he had below-
average athletic ability.10
Our overconfidence extends beyond self-analysis to our views of the
world. Let™s take a simple test: How many people were employed by
Wal-Mart in January, 2004, around the world? Without looking up any
information, write down a specific estimate. That may not seem fair, as
different people know more or less about Wal-Mart.
To make the question fair, in addition to your guess, write down an
upper-bound and a lower-bound number. Pick these bounds so that you
are 90% sure that the actual number of employees is between your
extreme high and your extreme low guesses.
If you answer 10 questions of this sort, nine of the answers should fall
between your upper and lower bound. Do you have your three numbers
for Wal-Mart? Your best estimate of the correct number, and lower- and
upper-bound numbers?
We™ll get to the correct answer in a moment. Under exactly these sorts
of conditions, when people are asked 10 such questions, they usually get
between two and four questions wrong.11 This poor performance comes
even after they have been told to give estimates wide enough to get only
one of the 10 questions wrong.
People fail in this guessing game because they place too much confi-
dence in their own estimates. Actually I ought to say that “we” fail, as I
Crazy People 19



have been tested in this manner and also came up overconfident. Before
I viewed my 10 questions, I resolved to make my lower and upper
guesses extremely wide. Even with that preparation, only 8 of my 10
upper and lower bounds contained the correct answer. Back to Wal-Mart:
In January 2004, the firm had 1.5 million employees.
The summary is that we come to the investing game with an analytic
tool kit that lacks some of the key tools required for investment analysis.
To add further insult to injury, our overconfidence makes us believe we
have the required skills for investing.



Split-Brain Investing

Even though our analytic investing tool kit is not complete, it is our best
hope to make good choices. An amazing fact is how rarely we use analy-
sis to make our decisions.
During the early 1990s my biggest investment was in Microsoft. One
evening I was standing outside my Harvard graduate dormitory chatting
with my buddy Matt. I said, “Matt, I have a puzzle that I want to discuss
with you. The puzzle is that Microsoft™s business is doing great, yet the
stock has not gone up in months.” Matt allowed me to blather on about
the fantastic business of selling software to the world, and then he asked,
“What is the price to earnings ratio of Microsoft?”
Silence fell as I realized that I didn™t have even a rough estimate of the
P/E for Microsoft. I was ignorant of a key fact in spite of spending many
hours a day reading financial papers. Furthermore, the P/E for any stock
is readily available. With 1993 technology it would have taken me about
5 minutes to walk to my room and find the Microsoft P/E in the Wall
Street Journal. With twenty-first century technology, such information is
available instantaneously on the Internet.
Because I am a curious person, I didn™t just hide my head after my
ignorance had been exposed. I started asking people about their invest-
ments. One person whom I spoke with (who was a financial professional)
owned Apple computer stock, and he extolled the virtues of the easy to
20 The New Science of Irrationality



use operating system. I then asked him, not about the stock price (which
he felt was low), but about the number of shares of stock that existed. His
answer was, “Geez, I don™t know. It must be millions.”
The number of shares is equally as important as the stock price in fig-
uring out the total value of the company. It is impossible to evaluate a
stock if one is ignorant of the number of shares. In other words, this
finance professional was as ignorant about his Apple computer invest-
ment as I had been in my Microsoft selection.
If you try this quizzing game with your friends, I suspect you will find
that most of them don™t know much about at least some of their invest-
ments.
These sorts of financial blind spots are, at least in theory, easily cor-
rected. The information is available, and I am in favor of everyone mak-
ing sure that they have done a solid analysis before making decisions.
The investing game is more subtle, however, than these stories suggest.
The reason is that human behavior, including investment choices, is
influenced to a surprisingly large extent by the lizard brain.
Many rational calculations are carried out in part of the brain™s pre-
frontal cortex, which is located above the eyes. When we think about our
investments in analytic terms, the prefrontal cortex is the boss. Compared
to other animals, humans have extremely large prefrontal cortexes, which
explains our superior reasoning ability.12 While we are therefore uniquely
able to make rational decisions, the lizard brain is also involved, and
more involved than we suspect.
Psychiatry has long examined the different parts of the brain and how
they interact. Sigmund Freud is most famously associated with his split-
brain view of the world, consisting of ego, superego, and id. Freud™s
view, of course, built on a long tradition that dates back at least to Plato.
Marvin Minsky is a modern scholar who postulates a brain filled with
more than Freud™s three competing forces. His opinion of many mental
entities is exemplified in the title of his book Society of Mind.13
When I was in one of his courses at MIT, Professor Minsky told a
funny story about his own brain. He said, “I was once scheduled to have
breakfast with President Gerald Ford. Although I don™t normally miss
Crazy People 21



appointments, I slept through this breakfast. I™ve never been prouder of
my subconscious.”
Professor Minsky was making a number of important points. First, his
prefrontal cortex was not in complete control of his behavior. Second, the
subconscious often has goals that are different from, and perhaps in con-
flict with, the goals of the prefrontal cortex. Third, and finally, the sub-
conscious is sometimes smarter than the prefrontal cortex.
My grandfather, who was known in our family by his nickname
Mandy, gave me my first lessons in the power of my own subconscious.
Mandy was a moderately famous psychiatrist who trained with Sigmund
Freud himself and who maintained a friendship with Sigmund™s daughter
Anna for many years. As a part of his training, Mandy was an accom-
plished hypnotist.
I was never hypnotized, but Mandy used the power of suggestion
whenever I had the hiccups. He would say to me”in a particular manner
that I have never been able to replicate”if you hiccup three more times,
I™ll give you a quarter. In all the times that he did this to me, I was never
able to produce more than one additional, pathetic hiccup. I™ve tried the
trick on other people, and it does not work for me. Apparently, something
in Mandy™s training allowed him to speak to my subconscious and alter
my behavior.
During the Korean War, the Chinese used knowledge of the subcon-
scious in their treatment of U.S. prisoners of war. The Chinese wanted
the U.S. soldiers to collaborate with them and used a variety of extremely
successful tactics ranging from brutal to cunning. In the excellent book
Influence, Robert Cialdini describes these tactics in detail, including an
incremental approach that I believe manipulated the subconscious.
Almost no one was willing to collaborate fully and immediately, but over
time people were pushed to more and more extreme behaviors. In the
end, one in three American P.O.W.™s committed some serious form of
collaboration, and some went so far as to abuse other Americans.14
For Americans who completely resisted, the Chinese would some-
times make a simple request. They would say, “We know that you are
unwilling to make statements against the United States, but would you
22 The New Science of Irrationality



mind rewriting this statement by one of your colleagues? You do not have
to put your name to the anti-American statement, nor tell anyone else of
your actions.” The Chinese found that this simple step was an important
one on the road to collaboration. After a prisoner had taken this act, he
was much more likely to begin making his own statements against the
United States.15 It seems that simply getting the brain to say or write
something begins to change attitudes. A similar logic underlies Dale
Carnegie™s suggestion to “get the other person saying, ˜yes, yes™ immedi-
ately.”
None of these examples prove that the subconscious is important. Per-
haps Professor Marvin Minksy was simply lazy on the morning of his
scheduled breakfast with President Ford. Similarly, we can™t know for
sure why my grandfather was able to stop my hiccups or why saying or
writing something changes our opinion. For proof of cause and effect we
need to reenter the scientific world.
Studying with people who have some sort of impairment sometimes
provides insight into the brain™s normal function. In our quest to under-
stand split-brain influences, we can learn from people who literally have
split brains. In most people the left and right sides of the brain talk to
each other via the corpus callosum, which physically connects the two
halves. Some people are born without a corpus callosum, and thus the left
and right sides of their brains do not know what is going on in the other
side. Studies of people with these split brains reveal that conscious parts
of our brain are not always in charge. These investigations are described
at length in a number of excellent books, including Professor Michael
Gazziniga™s The Mind™s Past.16
To investigate brain function, scientists presented signs with written
instructions to these patients with split brains. For example, the sign
might have said, “Please wave now.” The patients would comply with
these requests.
The interesting aspect of these split-brain studies came when the
patients were asked to explain their actions. The scientists made sure
that the signs were only seen in the left visual field where it would only
Crazy People 23



register in the right half of the brain. They made sure that the left hemi-
sphere of the brain, which controls speaking, did not see the requests.
Because the brains of these patients were split, one half of the brain knew
that the waving was a response to a request. The other half of the brain
was completely ignorant of the cause, and this half had to explain the
waving.
“Why are you waving?” Now the speaking part of the brain is faced
with a dilemma. It has no information about the cause of the waving.
Nevertheless it can sense that the body did just wave. Rather than confess
to its ignorance, the language part of the brain makes up a story. For
example, it might say, “I thought I saw someone I knew.” Similarly, when
half the brain is instructed to laugh, the ignorant half of the brain makes
up an explanation like “I™m laughing because you are funny guys.”
These studies and others lead to a startling conclusion. We are built to
cover up the fact that the lizard brain influences us. When we think we
have decided to take an action with our rational brain, we often have sim-
ply made up a story for the cause of action. As with Professor Minsky,
parts of our brain outside the prefrontal cortex often set the course and
leave the explaining to other parts.
Another interesting set of studies reveals the limits of our conscious
brain. This phenomenon is known as the McGurk effect; if you search the
web you should be able to experience it yourself. The McGurk effect
demonstrates that before sensations become consciously aware, they
have been altered by the nonconscious brain systems. Here™s how it
works.
When we listen to others speak, we use both our eyes and our ears.
This is true even for those of us who have not been trained as lip-readers.
In 1976, Harry McGurk and John MacDonald demonstrated this in the
following manner. Professors McGurk and MacDonald tape-recorded a
person producing the sound “Ba” and then combined that sound in a pre-
cise manner with a film of the same person saying “Ga.”17
What do you perceive when you hear the sound “Ba” while watching
lips making the shape of “Ga”? The answer is a fused sound best
24 The New Science of Irrationality



described as “Da.” The most interesting aspect of the McGurk effect is
that it never goes away. If you watch the video with your eyes closed, it
is clear that the sound is “Ba”; opening your eyes produces “Da.” Even
after watching the tape for hundreds of times, and even knowing the true
sound, the effect exists. We cannot use our rational brains to override the
nonconscious preprocessing of the information.
The McGurk effect demonstrates that preconscious processing affects
our fundamental perception of the world. Obviously, the prefrontal cor-
tex cannot be in complete control if it has information that is altered and
shaped by the other parts of the brain.
What have we learned so far? If we divide the brain into the prefrontal
cortex and the lizard brain, we have seen that our prefrontal cortexes are
often far from perfect. Next, we have seen that the lizard brain has a pow-
erful influence on our behavior. We are built to make errors and fall into
a variety of traps. Finally, we are built to create a cohesive story about our
behavior, which makes it hard to understand the sources of our own
actions.



The Lizard-Brain Goes to Wall Street

“Democracy™s the worst form of government except for all the others,”
said Winston Churchill. Similarly, rational investing, using our less than
perfect analytic system is the worst way to make money except for the
alternative of using our lizard brains. As we will see, the lizard brain
pushes us toward destructive acts.
The only thing worse than having a flawed prefrontal cortex exerting
weak control is not having the prefrontal cortex in charge. The most
famous example of this comes from the sad tale of Mr. Phineas Gage.
The incident happened on September 13, 1848, and the original news-
paper article in the Free Soil Union tells the story.

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