beth Hurley, playing â€śminxâ€ť-like agent Kensington, became the partner
of our recently defrosted superspy.
Agent Kensington introduces herself, â€śMr. Powers, my job is to accli-
matize you to the nineties. You know, a lotâ€™s changed since 1967.â€ť
Austin replies, â€śNo doubt, love, but as long as people are still having
promiscuous sex with many anonymous partners without protection
while at the same time experimenting with mind-expanding drugs in a
consequence-free environment, Iâ€™ll be sound as a pound!â€ť
The joke, of course, is that the norms of the 1960s regarding sex and
drugs had become abnormal by the 1990s. This is not unique to the
1960s. Modern societies change very rapidly, and we are built to be per-
petually behind the curve, thinking that this generationâ€™s fad is a perma-
nent feature of human existence.
Like other aspects of human nature, our tendency to underestimate
change may reflect our ancestral past. For tens of thousands of years, at
least up until the invention of agriculture, our ancestors lived in a world
where many important attributes never changed.
Our human tendency to expect that the future will be like the past
may have helped our cavemen and cavewomen ancestors, but it does
not work well in a rapidly changing modern society. It works even less
well in financial markets where todayâ€™s fad is likely to be tomorrowâ€™s
loser. Recognition of the current situation is crucial as my friend Matt
A few years ago, Matt had a romantic dinner in Budapest overlooking
the Danube River. A violinist approached the table while playing enthu-
siastically. After he completed the piece, the musician asked Matt if he
268 Profiting from the New Science of Irrationality
had a request. Suave and confident in front of his date, Matt said, â€śHow
about the Blue Danube?â€ť The violinist responded, â€śThat was it.â€ť
Similarly, if we had the chance to request an investment climate, we
might ask for a massive bull market in stocks, bonds, and real estate. We
would love a setting where financial risk was rewarded almost without
regard to the type of investment (even surfers could get rich in such an
environment). To which the reply would have to be, â€śThat was it.â€ť
We have just lived through an atypical and unsustainable financial
period. In recent decades, stock prices have risen at almost three times
their natural speed limit. Similarly, interest rates have fallen toward zero,
fueling the real estate market with cheap mortgages. Finally, with our
massive trade deficit we are racking up enough debts to make Uncle Sam
an international beggar.
None of these trends are sustainable. By themselves, however, the
required changes do not mean doom and gloom. Theoretically, stock
prices can rise indefinitely (albeit at a slower pace), interest rates can
remain low (even if they canâ€™t decline much further), and our adjustment
to a trade surplus can lead to greater employment (even if this means
lower real wages).
The danger lies not in the macroeconomic adjustments we face, but in
our psychology. Just as the fleeting nature of the 1960s culture surprised
a defrosted Austin Powers, we are not built to recognize the unsustain-
able facts about our world. It is an economic truth that the financial future
must be different and worse than the fantasyland of the past generation.
It is a psychological truth, however, that most of us will realize this
change only after it has occurred and when it is too late to find profits.
The current financial environment is kryptonite for the lizard brain.
Just as superman was really only vulnerable to kryptonite, the lizard
brain gets us in particular trouble when powerful trends must end. The
backward-looking lizard brain is literally surprised when patterns donâ€™t
repeat. The golden generation of rewarding risk has set us up for finan-
cial losses. Because our lizard brains are set up to collide with economic
necessity, these are the meanest of markets.
Timely Advice 269
Is It Time to Take Less Financial Risk?
â€śWhen you have eliminated all which is impossible, then whatever
remains, however improbable, must be the truth.â€ťâ€”Sherlock
In answer to Adamâ€™s question, Mean Markets suggests that none of the
big three investment alternativesâ€”stocks, bonds, and real estateâ€”is
likely to provide great returns. Based on macroeconomic analysis these
traditional investments range from fairly valued to expensive. Impor-
tantly, none of them appear to be cheap.
While none of these investment alternatives looks cheap, standard
economic analysis doesnâ€™t find any of them to be wildly overpriced,
either. Therefore, one might conclude that we will see a relatively benign
The science of irrationality, however, reaches more pessimistic con-
clusions. We are built to do that which has worked, and we have just lived
through an extraordinary period that rewarded financial risk. Further-
more, the single best guide to future performance is to bet on that which
is unloved. Wall Street, Main Street, and both neoclassical (the â€śrationalâ€ť
school) and behavioral economists (the â€śirrationalâ€ť school) are betting
that risk will be rewarded.
In The Adventure of the Silver Blaze, Sherlock Holmes solves the case
in an unusual manner. Holmesâ€™s colleague, Inspector Gregory, asks, â€śIs
there any other point to which you would wish to draw my attention?â€ť
Holmes responds, â€śTo the curious incident of the dog in the night-time.â€ť
Inspector Gregory protests, â€śThe dog did nothing in the night-time.â€ť To
which Holmes concludes, â€śThat was the curious incident.â€ť
Sherlock Holmes solved the case because of the â€śdog that didnâ€™t
bark.â€ť Similarly, the Mean Markets conclusion is that the best financial
approach today might be to reduce risk. This is the opposite of the con-
ventional wisdom. The very core of the efficient markets hypothesis is
that investors who want high returns must accept high risk.
270 Profiting from the New Science of Irrationality
The â€śinvestment that doesnâ€™t pay todayâ€ť may solve the current finan-
cial dilemma. Because markets are sometimes wildly irrational, the
â€śreward only for taking riskâ€ť equation can be reversed. The analysis of
this book suggests that now is one such time. Low-risk investments, even
those that pay close to nothing today, may be the long-term road to wealth.
Financial success might require hunkering down in a low risk posture
until markets become irrationally cheap. When the financial world is
filled with pessimism and others are selling their risky assets, those savvy
investors who are prepared will be able to scoop up bargains.
Thus, the Mean Markets and Lizard Brains answer to Adamâ€™s question
is that each of us should reduce our financial risk to a level far below where
we feel comfortable. Our lizard brains have been fooled by the last 20 years
of unsustainable gains. Thus, it is likely that we are all walking around with
overly optimistic views of the world. We are taking more financial risk than
we think we are, and most of us are taking more risk than we would want
if our lizard brains allowed us to see the world clearly.
For those who want to take the Mean Markets and Lizard Brains
advice to reduce financial risk, here are eight steps that can be taken
Risk Reducer #1: Allocate More Money to Lower-Risk Assets
Sell some stocks. Shift some money from growth stocks to value stocks.
Increase holdings of cash and short-term securities.
Risk Reducer #2: Buy Some Inflation and
Buy inflation-protected bonds in the form of Treasury Inflation Protected
Securities (TIPS) or Series I U.S. Savings bonds. Buy the stocks of com-
panies that make the products that might go up in price (e.g., drug com-
panies, oil companies).
Risk Reducer #3: Buy Short-Term Bonds
Buy bonds that mature soon, sell longer-term bonds.
Timely Advice 271
Risk Reducer #4: Live in a Smaller House
Own a house that is less valuable than the one you plan to live in five
years from now.
Risk Reducer #5: Have a Fixed Rate Mortgage
Variable-rate mortgages are risky.
Risk Reducer #6: Invest in Other Currencies
Buy bonds that pay European euros or Japanese yen. Buy stock in com-
panies that make a lot of money outside the United States.
Risk Reducer #7: Pay Off Your Debts
Rewards go to those with strong financial structures able to withstand
(and profit from) adversity. Reduce your debts to build a strong hand.
Risk Reducer #8: Seek a Secure Paycheck
Now might not be the best time to leave a boring but safe job in order to
start a restaurant or work for a start-up company.
The Risk of Low-Risk Investing
The Mean Markets recommendation to reduce financial risk is grounded
in three macroeconomics truths:
1. Stock prices cannot grow faster than the economy forever.
2. Interest rates cannot go below zero.
3. The United States cannot run a trade deficit forever.
While these three are facts, picking the correct investments to profit from
these changes is an exercise in economic forecasting. As we all learned,
economic forecasts often boldly go to incorrect conclusions.
In the Foundation series of science fiction books, Isaac Asimov tries
272 Profiting from the New Science of Irrationality
something far more difficult than economic forecasting. Asimov suggests
that the field of â€śpsychohistoryâ€ť can predict the future of society. Psy-
chohistory is â€śthat branch of mathematics which deals with the reactions
of human conglomerates to fixed social and economic stimuli.â€ť Psy-
chohistorians claim that while individual behavior is unpredictable,
social trends can be forecast based on the laws of probability.
Asimovâ€™s fictional psychohistorian, Hari Seldon, correctly predicts
events for hundreds of years. Long after his death, the great Seldonâ€™s pre-
recorded comments are played to generations of leaders on a secret
schedule, and his accuracy would make even Nostradamus envious.
Then, directly in opposition to Seldonâ€™s predictions, the Foundation is
Even in a novel, forecasts tend to be wrong! How did Asimovâ€™s hero
fail? The answer is that the Foundationâ€™s conqueror is a mutant called
â€śthe Mule.â€ť Based on probability, the chance of such a leader arising was
so small that the laws of psychohistory could not anticipate such an
unlikely turn of events.
Interestingly, wikipedia, an online encyclopedia, lists macroeconom-
ics as a â€śsee alsoâ€ť topic under the description of Asimovâ€™s psychohistory.
Like psychohistory, economic forecasts are particularly bad at anticipat-
ing the effect of novel and unlikely events. If there is to be such a â€śmuleâ€ť-
like event within economics, it is the productivity increase that is
possible because of information technology.
Everyone has been touched profoundly by information technology.
My own personal stories stretch from â€śknowledge-workâ€ť to manufactur-
ing. The Harvard Business School now uses an electronic course plat-
form to coordinate all teaching activities and distribute materials to
students. This has made my life as a professor vastly easier. All of my
lectures are electronically uploaded to the web from my office and
accessed in the classroom. Printed material is distributed to hundreds of
students with the literal click of a button.
More concretely, my father-in-law Joel works for an American com-
pany that actually manufactures somethingâ€”very high quality flashlights
(some costing hundreds of dollars). I visited the flashlight factory and
Timely Advice 273
found a giant room with a bunch of intelligent machine tools and three
people. The people maintain the machines and feed them raw materials.
With the right tools, three people can make a huge number of flashlights.
Everybody has similar experiences, and many are more dramatic than
mine. Day by day, and in countless ways, information technology is mak-
ing it easier to produce goods and services. As foreseen by the great
economist John Maynard Keynes, productivity increases driven by infor-
mation technology hold the promise of allowing humans to combine
leisure with material excess.
Productivity thus holds the potential to cure Americaâ€™s financial woes.
Many of those most pessimistic about our financial future point to the
massive debts we have both as individuals and through our government.
For example, market seer Bill Gross of PIMCO is on record with his pre-
diction that the Dow Jones Industrial Average will decline to 5,000.1 One
of the reasons that Mr. Gross cites for his pessimism is a total U.S. debt
level thatâ€”measured against the size of the economyâ€”is the largest in
history, exceeding even the bubbly 1920s.
Similarly, Robert Prechter (of Elliot Wave fame) cites similar debt sta-
tistics in many of his works, including his 2003 book Conquer the Crash.
Mr. Prechter sees the possibility for the Dow to return to 1,000 or lower,
making Bill Gross seem optimistic.2
Debt levels are indeed high. Furthermore, many aspects of our indebt-
edness are relatively new. The first â€śplasticâ€ť money, for example, was
invented only in 1950, and widespread use of credit cards didnâ€™t take off
until the invention of the magnetic strip in the early 1970s.3 Now that
credit cards are ubiquitous, almost everyone drags around a hungry debt
balance that requires constant feeding. We are acclimatized to think of
such indebtedness as natural. Scholars of irrationality and cycles, how-
ever, point out that credit junkies can convert to frugality with chilling
economic effects. Thus, the indebtedness of our society threatens our
Just as a highly unlikely event surprised the laws of psychohistory,
abnormally high levels of productivity can protect us from the seemingly
inevitable consequences of our indebtedness.
274 Profiting from the New Science of Irrationality
Through a similar lucky event, I survived a bout of indebtedness some
years ago. While I was a student getting my Ph.D., Progenics Pharma-
ceuticalsâ€”the company that I had helped start, and for which I had
served as president and chief financial officerâ€”prepared for its initial
public offering (IPO). With this event, I would be able to sell my shares
and switch from bicycle-riding student to millionaire.
Because I know that markets are fickle, I resolved not to count my
chickens too soon. Or at least not to spend them. So my goal was to act
as if I were still poor until the cash hit my bank account. This, of course,
proved impossible. In almost every conceivable way my expenses crept
up. I took cabs, bought extra appetizers at meals, and flew to New York
instead of taking the train. These expenses added up to some thousands
of dollars of debts. Not to worry, soon the money would roll in.
After some months of trying to sell the IPO without much interest,
Progenics decided to abandon its public offering. I was left with my debts