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Phineas P. Gage, a foreman on the railroad in Cavendish was
engaged in tamping for a blast, the powder exploded, carrying an
Crazy People 25



iron instrument through his head an inch and a fourth in circumfer-
ence, and three feet and eight inches in length.

Amazingly, Gage recovered quite nicely from having this enormous
metal bar pass through his brain. The bar weighed more than 13 pounds
and was actually an inch and a half in diameter (larger than the circum-
ference reported in the paper). Within less than a year of the accident,
Gage felt strong enough to return to his railroad job. Furthermore, to a
large extent his mental processes seemed intact.
His colleagues, however, soon found that Gage was not himself. He
suffered from a number of new negative personality traits, and his
coworkers concluded that he was “no longer Gage.” In particular, Gage
lost the ability to execute plans that he made for the future. Even if his
mental functions were unimpaired, the fact that his prefrontal cortex was
no longer in charge prevented him from returning to his job as foreman
and he subsequently left the employ of the railroad.18
The list of human foibles and weaknesses is a long one. We™ll now
look at the most important demonstrations of individual irrationality that
apply to investing. Readers who are interested in the topic more broadly
are encouraged to read Richard Thaler™s The Winner™s Curse, or Nobel
Laureate Daniel Kahneman™s Heuristics and Biases (edited by Kahne-
man as well as Thomas Gilovich and Dale Griffin).19



Irrationality #1: Pride Goeth
before a Financial Loss

Paul Tudor Jones II is a legendary trader who has made hundreds of mil-
lions of dollars. Some of his exploits are covered in Market Wizards.20
My college roommate from the University of Michigan, Peter Borish,
worked with Paul. Through Peter, I met the legendary trader and was able
to spend some time with him.
You might think that great traders don™t suffer from the same biases as
the rest of us. That may be true, but my impression is that they are more
26 The New Science of Irrationality



effective at limiting the damage caused by self-destructive aspects of
human nature. When I visited him, Paul Tudor Jones had two handwrit-
ten signs over his desk. I interpreted them as messages designed to help
his prefrontal cortex control his lizard brain.
One sign said, “Observe that the blade of grass that resists the lawn
mower gets cut down, while the blade that bends remains uncut.”
In many areas of our lives, the right course requires us to swallow our
pride, take a loss, and move on. If we are unwilling to bend, we, like the
blade of grass, will suffer.
One of the most-studied areas in behavioral economics documents
how people™s stubbornness costs them money. The setting is called the
“ultimatum game,” and it is a very simple negotiation between two peo-
ple. The game asks them to divide up a lump sum of money through a
process that is decidedly unfair. One of the pair, called the Proposer, gets
to suggest how the money should be divided. The second, called the
Responder, is not allowed to counterpropose, but must accept or reject
the ultimatum offer.
I played the ultimatum game in a workshop run by my advisor, Nobel
Prize winner Professor Vernon Smith. In the version that I played, I won
the right to have the proposal power by scoring well on a trivia question.
I now had $100 and the right to set a take-it-or-leave-it offer to another
workshop participant. Furthermore, the decision was made in an anony-
mous manner. Neither my counterpart nor I knew, or would ever learn,
each other™s identity.
So I have $100. I can make an offer to my hidden counterpart that she
or he can earn $10, $20, or any multiple of $10. If my offer is accepted, I
keep my part of the $100 and my counterpart goes home with whatever
cash I have offered. If my offer is rejected, we both earn $0. What to do?
Let™s assume for a moment that one™s goal is to make as much money as
possible. (That was my goal in the $100 ultimatum game.)
Here™s how I analyzed the game. The responder is in a tough situation.
She or he can take whatever I offer or get $0. So even if I offer a small
amount, the responder earns more money by taking my offer than by
Crazy People 27



rejecting the offer. Based on this, I decided to offer $10 to my counter-
part, while retaining $90 for myself.
Vernon Smith ran the workshop by having us first play the games for
real money, then before we learned of our outcomes, we would study
previous research on the topic. As I was thinking of how I would spend
my $90 (I was confident that my offer would be accepted), we began
learning of study after study where responders said “screw you” to low
offers like mine.
Professor Werner Guth and colleagues performed the first ultimatum
study, published in 1982. For stakes of 10 German D-marks (this was
before the introduction of the euro), the players exhibited pride or a sense
of fairness. In fact, 20% of responders rejected the offers. Furthermore,
the average proposal was much nicer than mine. While I had offered a
mere 10% of the financial pie, the first ultimatum game proposers offered
an average of 30%.21
Since the original study, the basic findings have been replicated in lit-
erally hundreds of studies. In study after study, all around the world, peo-
ple reveal themselves to be proud. They are willing to lose money to
retain their self-esteem.22
Initially, many people claimed that the results couldn™t be true, and
suggested the rejections were artificial because the monetary stakes were
so low. Vernon Smith and his colleagues tested this supposition by hav-
ing U.S. participants play the game for $100. They found no difference
between play for $100 and play for $10.23
The ultimatum game has been taken around the world, in order to test
the role of culture and to increase the stakes even higher. In countries
such as Indonesia, researchers have organized ultimatum games played
for several months™ salary. Even with such high stakes, people are willing
to walk away from unfair offers.24 And, in spite of cultural variation, Pro-
fessor Guth™s original findings have also been found among nonindustri-
alized people who still hunt animals and gather plants for a living.25
Are ultimatum game rejections irrational? Not necessarily, but they def-
initely cost the participants money. Recall that these games are generally
28 The New Science of Irrationality



played just one time between anonymous counterparts who will never
see each other again. A decision to reject an offer under such conditions
means a loss of money that will never be recouped.
In many financial situations, we are faced with taking a small loss now
or digging in our heels. The best course, especially if one wants to earn
money, is to admit to small defeats and move on.
I interpret Paul Tudor Jones™ sign as a note to his lizard brain from his
prefrontal cortex. Here is my interpretation: “Dear Mr. Lizard Brain, I
know that you are built to be stubborn and proud. Although you like to
behave that way, I (Mr. Prefrontal Cortex) prefer money. Therefore I™m
going to force you to take the profitable and not the proud path.”
New ultimatum game research in the field of neuroeconomics shows
us exactly what part of the brain operates to make people lose money.
Professor Alan Sanfey and colleagues had people play the ultimatum
game while their brains were scanned by an fMRI machine. People con-
fronted with small offers ($1 or $2 out of $10) had greater brain activity
in the bilateral anterior insula (not part of the prefrontal cortex), and sub-
jects with higher activation levels in this area were more likely to reject
these small offers.26
These ultimatum game results provide us with direct, scientific evi-
dence that parts of the human brain outside the prefrontal cortex push
people down a path that costs them money. As I write this, we don™t have
similar evidence for the brain location of most other economic biases, but
we soon will. My prediction is that most “irrational” behavior will be
found to be located outside the prefrontal cortex.
Finally, in my own research, I have found that men who reject small
ultimatum game offers have much higher levels of testosterone than
those who accept.27 Often associated with muscle mass, testosterone
plays a crucial role in the maintenance of dominance hierarchies. For
example, I measured the testosterone levels of Howard Stern and others
on his team. Howard, the socially dominant male in the group, had by far
the highest testosterone. My friend Vinnie Favale, a big shot at CBS and
a frequent guest on the show, had the second highest testosterone level.
Crazy People 29



Both Howard and Vinnie came in above younger men (Gary, KC, John)
who are lower down in the show™s hierarchy.
These results suggest that the lizard brain is not so crazy after all. In
natural settings where people meet over and over again, it pays high-
testosterone people to use conflict as a tactic to achieve their goals.
Testosterone activates the lizard brain and makes some people more will-
ing to be confrontational. In the unnatural setting of the laboratory, how-
ever, confrontation in the ultimatum game is costly, not beneficial. Like
laboratories, financial markets are unnatural environments, and this
explains why our instincts often cost us cash.
What do you think happened to my offer of $10 out of $100? After
learning that many people prefer no money to a small percentage, I
feared all was lost. Furthermore, our group results showed that pride
flowed strongly among these graduate students. Three of my fellow stu-
dents had faced $10 offers, and two had rejected them. One person had
even rejected $30 out of $100! By good chance, however, my puny offer
of $10 had been accepted.



Irrationality #2: Fear of Losses Causes Losses

Consider your willingness to participate in the following risky gamble. A
coin toss decides if you win or lose. If you lose, you pay $5. If you win,
the jackpot is yours. Professor Kahneman asked people to tell him the
smallest jackpot that would make this gamble worth the potential loss
of $5.
What is your answer? If your answer is more than $5, you hate losses.
In fact, the average answer to this question is more than $10. Professor
Kahneman interprets this to mean that people hate losses much more
than we enjoy equal gains. We are not willing to lose $5 for the possibil-
ity of gaining just $5; we need a bigger jackpot to justify the risk.28
Professor Kahneman calls our answers to this question, and the results
from related research, “loss aversion.” Among all the findings that led to
30 The New Science of Irrationality



his Nobel Prize, loss aversion is one that Professor Kahneman rates as
among the most significant. While hating to lose money might seem like
a good thing, it can cause us to lose money.
The infamous trader Nick Leeson exemplifies the troubles that loss
aversion can cause. Leeson was the “Rogue Trader” who brought about
the collapse of Barings Bank. Interestingly, Leeson himself wrote a
book detailing his mistakes that was made into a movie starring Ewan
McGregor.29 (I suppose I™d be tempted to commit some misdeeds if I
could be sure to be portrayed by a dashing actor.)
Barings Bank was one of Britain™s most prestigious financial institu-
tions. It was destroyed when Leeson lost nearly 1 billion British pounds
in a failed speculation. Although there are many reasons for the behavior,
it is consistent with that caused by loss aversion.
At first glance, loss aversion sounds rational. Who likes losing
money? No one. But consider what happens when you have lost a little
bit of money. Now, the strong hatred of losses creates perverse incen-
tives. That is to take big, stupid risks with the possibility of avoiding the
label of loser.
Nick Leeson didn™t lose his billion pounds in one go. In fact, he made
a financial bet that lost a relatively small amount of money. Rather than
accept his small loss, Leeson dramatically increased his bet. He contin-
ued to add to his losing position, hoping that he could get back to even.
In the end, it was precisely his hatred of losses that led him to massive
and destructive losses.
More than loss aversion caused the Nick Leeson blowup, but the gen-
eral lesson is valid. Our hatred of losing money can push us toward tak-
ing bad risks, which in turn causes us to lose money.



Irrationality #3: Finding Patterns
in Random Walks

One of B.F. Skinner™s most famous experiments created what he labeled
“superstitious” pigeons.30 The experiment provided food to the pigeons
Crazy People 31



at regular intervals. In many of Skinner™s experiments, he rewarded
pigeons for particular acts. By reinforcing certain behaviors, Skinner was
able to produce pigeons that could play ping-pong, or even pilot bombs.
In his superstition experiment, however, Professor Skinner gave the
pigeons food without attempting to reinforce any particular behavior. In
fact, he gave the pigeons food “at regular intervals with no reference
whatsoever to the bird™s behavior.”
The outcome of this experiment was superstitious pigeons. Even
though the food was given out on a fixed schedule, the pigeons attempted
to make sense of the outcomes. (Of course, they didn™t really try to make
sense of the outcomes; they have tiny brains and even tinier cortexes.)
They did, however, change their behavior in ways that may seem quite
rational. The pigeons tended to duplicate their own processes that pre-
ceded food. Skinner writes,

One bird was conditioned to turn counter-clockwise about the cage,
making two or three turns between reinforcements. Another repeat-
edly thrust its head into one of the upper corners of the cage. A third
developed a “tossing” response, as if placing its head beneath an
invisible bar and lifting it repeatedly. Two birds developed a pendu-
lum motion of the head and body, in which the head was extended
forward and swung from right to left with a sharp movement fol-
lowed by a somewhat slower return.

These pigeons were classic “stimulus response” machines. They repli-
cated actions that led to good outcomes and avoided actions that led to
bad outcomes. The actual result was quite amazing. Each pigeon devel-
oped its own superstitious behavior. These superstitious pigeons are
crazy, because their outcome was not affected by their actions. Neverthe-
less, the small-brained creatures sought a pattern in their experimentally
mad world. Professor Skinner concludes,

The experiment might be said to demonstrate a sort of superstition.
The bird behaves as if there were a causal relation between its
32 The New Science of Irrationality


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