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behavior and the presentation of food, although such a relation is

Surely, we humans are much smarter than these pigeons? Yes, with our
large prefrontal cortexes we are indeed much smarter. Outside the pre-
frontal cortex of our brains less rational notions thrive in the lizard brain.
We humans retain brain structures that are little different from the homol-
ogous parts of brains in other animals, even some that we might label as
quite primitive. The lizard brain is an active, albeit often silent, actor in
human decision making.
Consider the following two sequences of heads (H) and tails (T):

Sequence A: H-T-H-T-H-T-T-T-H-H-T-T-T-T-T-T-H-T-H-H
Sequence B: T-H-H-T-T-H-T-H-H-T-H-H-T-H-H-T-T-H-T-T

I just created A and B by using two very different processes. I con-
structed one of the two sequences analytically. I produced the second
sequence by flipping a quarter 20 times just now in my office. So one of
the sequences was randomly generated by coin flips, while the other was
So which sequence, A or B, is a random sequence of coin flips? Take
a guess before I provide some hints.
Let me tell you more details about the nonrandom process, and you™ll
be able to figure it out. In the constructed sequence, I never allowed more
than two consecutive heads or tails. Similarly, in this constructed version,
I did not allow a strictly alternating sequence of heads, tails, heads to per-
sist for more than three times.
So sequence A, which contains a long string of consecutive tails is part
of the random sequence. Sequence B is the nonrandom sequence. In
experiments of this nature, people tend to pick the wrong sequence.31
The point is that our lizard brains seek a logical pattern to illogical
behavior. Stock prices have a large random component, yet we are all
built to search for patterns in that noise. Many investment strategies are
Crazy People 33

no better (and perhaps no less entertaining) than the dance moves of our
superstitious pigeons.

Irrational Nobel Prizes

The academic battle over irrationality at the individual level is largely
complete. There is overwhelming evidence that we do crazy things that
defy the laws of logic. The 2002 Nobel Prize in economics, awarded
jointly to Professor Daniel Kahneman and Professor Vernon Smith, is
symbolic of the victory of those who believe that irrationality is a funda-
mental part of human nature. In the next chapter, we will see how these
quirks and biases play out in financial areas.
Before moving on, however, we must address what may be the mother
of all irrationalities, that of self-control. In almost all models of rational
behavior, people coolly trade off the future against the present. Should I,
for example, pay more money up front on my mortgage and thereby buy
myself a lower set of future payments? The single, correct answer is to
weigh the cost against the benefit, using the appropriate formula.
While this rational view of decision making is appropriate, and I actu-
ally use it from time to time, many other choices are made by far more
whimsical processes.
Consider the discussion that I have with my wife, Barbara, about four
times a week. As we drive home in the evening, I suggest that we pull
into the empty gas station and top off our tank. Unless the gas gauge is
banging on empty, she argues against stopping. “Please, don™t stop. I™m
really tired, and I need to get home right now.”
The result of not topping up is that when we are about to leave on a
trip, we need to go to the gas station. These trips often occur during busy
afternoons and take much more time and stress than the late-night top off.
On each night, however, Barbara looks forward to a blissful future with
no time constraints and no fatigue.
Our little game where I threaten to stop in the evening has taken a
34 The New Science of Irrationality

humorous turn analogous to the “cheese shop” game of Monty Python.
That game is played as follows. One person, the customer, asks for a vari-
ety of cheese. The second person, the store owner, gives an excuse for
why the cheese isn™t available (for example, “the cat just drank it” was
one answer in the original skit for a particularly runny cheese). Each
player has to come up with a unique cheese or excuse, and the game ends
when one side runs out of new ideas.
In our gasoline station variant, I propose new reasons why we have to
stop and Barbara gives reasons why the present is a uniquely bad and
inconvenient moment.
The gasoline game is simply a trivial demonstration of a self-control
problem. Most of our bad decisions involve an inappropriate trade-off
between today and tomorrow. We know that we should work hard now
and play later, but we are just so busy now.
Behavioral economists have documented our self-control problems. In
a variety of interesting settings we place too much weight on the present
and too little on the future.32 We use our lizard brain when we ought
employ our prefrontal cortex.
Woody Allen says that the brain is his second favorite organ. As we
have seen, our brains are not monolithic bastions of rationality. While we
have a powerful prefrontal cortex with special analytic power, it has only
limited ability to control the wild and powerful lizard brain.
chapter three

Mean Markets and the New Science
of Irrationality

How Can a Market Be Mean?

There™s a Wall Street adage that “markets move to frustrate the most peo-
ple.” There is some suggestion that this is true. Contrarian lore tells us
that when people are optimistic markets are likely to fall and pessimist
sentiment is said to predict rallies. The more extreme the investors™ emo-
tions, the more powerfully the market will move”but in the opposite
direction of sentiment.
A “mean market” is one in which people are systematically out of
sync with opportunity. In a mean market, our lizard brain screams at us to
buy just before a collapse and makes us want to sell in terror just before
a rally. If markets did create such emotional cruelty, especially because it
costs us cash, they would indeed be mean. Are markets really mean,
moving to frustrate us systematically?
There is one kind of market that can never be mean, and that is a
rational market. To prove this point, try to be really wrong in predicting

36 The New Science of Irrationality

coin flips. For example, flip a coin 100 times and predict each flip. It is
almost impossible to get significantly more than half wrong. This is true
regardless of what system is used to predict the outcome of each flip”
astrology, tips from friends, or always predicting heads. Because a fair
coin is unpredictable, it is equally cruel (and kind) to all efforts at pre-
In a rational market, prices move like coin flips. In such a market, the
chance of an up move in a short period of time should be almost exactly
50%. Furthermore, as with coin flips, nothing is supposed to be able to
predict price moves. In such a market, all strategies to predict future price
changes will be no better than chance. The bad news is that only those
who are very lucky can do really well in a rational market. The good news
is that it is also almost impossible to do really poorly in a rational market.
Therefore, for markets to be mean they must be irrational. We tackle the
issue of market rationality first, and then return to mean (and nice) markets.

Are Markets Crazy?

We know that people are crazy. In addition to the scientific evidence that
has piled up over the last several decades and that we reviewed in Chap-
ter 2, surely our daily experiences confirm, at least anecdotally, that we
are just not as rational as we think we are (or at least not as rational as
old-school economists assume).
While the case against individual rationality is closed, this is not suffi-
cient to prove that markets are irrational. Consider what happens when
you put a bunch of crazy people together. Is the result more chaos, or can
order emerge even from a group of irrational people? It turns out that
both chaos and order are possible.
In February 2004, hundreds of people were killed in a stampede out-
side of Mecca, Saudi Arabia. As part of the hajj, huge numbers of Mus-
lim pilgrims were participating in a rite where each one throws a pebble
at a historical pillar symbolizing the devil. The crowd crushed the vic-
tims as people in the back pressed forward to reach the pillar within the
Crazy World 37

appropriate time frame for the ceremony. With its large crowds, the hajj
has a history of deadly stampedes.
Rock music fans can be almost religious in their fervor, and many con-
certs have turned deadly. In 1979, 11 fans were killed at the Who concert
in Cincinnati. The causes of stampedes are often very minor; things turn
deadly only when many individuals compound the original problem.
A survivor of a stampede at a Pearl Jam concert that killed eight said,
“Things were really great, and we wanted to move up.” As people moved
closer to the stage, everything was fine until, “The pressure from behind
was too great” and the desire to have a better view led to death. Similarly
a post-concert stampede in Belarus that killed 53 was caused by a hail-
storm that made people rush to enter a metro station. In the dash for
cover, a few young women in high heels fell and thus began a deadly
chain reaction.
In the case of stampedes, groups of individuals, each one of whom
may even be acting rationally, end up with very bad outcomes. The over-
all system works to magnify problems.
In contrast, there are other situations in which the right guidance can
turn a mob of unruly individuals into an efficient team. I think of one
such example whenever I board an airplane. My standard experience is
that the boarding process is extremely inefficient. As soon as allowed,
everyone surges forward, rushing to stuff their bags into overhead com-
partments. Invariably, as I work my way to my seat, I have to wait for the
aisle to clear.
In contrast to this inefficient, clogged mess, I had one boarding expe-
rience that was almost magical. I was flying from Frankfurt, Germany,
back to the United States on a flight that was extremely crowded. Rather
than let us mob the plane, one of the gate agents organized an efficient
With just a few moments of effort, this agent organized us so perfectly
that passengers in row 56 were at the front of the boarding line, followed
by those in row 55, and so forth. With this setup, there were no clogs in
the aisles and hundreds of people boarded the plane effortlessly in just a
few minutes. It was a miracle, and one that I wish for on every flight.
38 The New Science of Irrationality

On the way to his Nobel Prize, Professor Vernon Smith demonstrated
that this phenomenon extends beyond boarding planes. There are situa-
tions in which the outcome is efficient beyond any reasonable expecta-
tion. Professor Smith™s work concerned the magical ability of supply and
demand to meet.
The question that Professor Smith addresses relates to the following
joke: How many economists does it take to screw in a lightbulb? None;
the invisible hand will do it.
Similarly, how is it that I can walk into the small convenience store in
my condominium building five minutes before it closes and know that I
will find Ben & Jerry™s chocolate fudge brownie ice cream? The answer
is that, as Adam Smith wrote, the self-interest of the store owner, work-
ing within a framework of law, almost magically provides the goods that
I desire (or in this case, the ice cream that my wife Barbara desires).
Professor Smith found that supply and demand work even better than
expected. Economists have proven that supply and demand work well
when people are rational and have excellent information about the world.
Professor Smith™s work showed that even when people know nothing
about their world (and are irrational), supply and demand do work their
invisible magic. Collective efficiency sometimes arises from individual
ignorance and irrationality.1
Even with the evidence that individuals are crazy, it is possible that
collections of individuals, operating in markets, will make rational finan-
cial decisions. The question remains: Are financial markets more similar
to stampedes where small problems multiply, or to miraculous plane
loadings where crazy people are guided to efficient outcomes?

The Efficient Markets Hypothesis

The standard view in finance is that markets remove individual irra-
tionality. This “efficient markets hypothesis” says that just as self-interest
allows me to find my wife™s ice cream in the local store, prices are pushed
to the “right” level by an efficient and invisible hand.
Crazy World 39

I recently employed a variant of the efficient markets hypothesis in a
mundane setting. The trustees of my condominium complex renovated a
little exercise room and during the process removed the chin-up bar: the
one piece of equipment that I used regularly. To lobby for a new chin-up
bar, I attended a trustees™ meeting. During the meeting, I was surprised to
find that the trustees were considering spending almost half a million
dollars (some of it mine) to buy an apartment for our superintendent.
Among the justifications for this purchase was an analysis that said
buying the apartment was a “can™t lose” proposition. Since our building
is near both Harvard and MIT, demand for housing was sure to be strong
and the apartment™s price would definitely increase, or so the argument
Even though I wanted to discuss biceps, I found the lure of the “can™t
lose” investment compelling. Accordingly I asked, “If the price of the
apartment is so low that it will definitely rise, why is the owner willing to
The trustees found great wisdom in this question and invited me to
attend future meetings. There is indeed wisdom in my question, but the
credit goes to a Frenchman named Louis Bachelier, not to me.2 While he
was a graduate student about 100 years ago, Bachelier asked a variant of
this question about financial markets.
When two people trade with each other, Bachelier suggested that a
good deal for one means a bad deal for the second. Thus, when two peo-


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