science, mere dogma.
â€śDouble, double toil and trouble; Fire burn, and cauldron bubble,â€ť say
the witches in Macbeth, associating bubbles with troubles. However,
these same witches also note that in some situations â€śfoul is fair and fair
is foul.â€ť When someone sells a house to buy a ridiculously expensive
tulip bulb, for example, another person gets to buy a house for the rock-
bottom price of one tulip bulb.
Investors who accept the dogma of market efficiency give up the
opportunities that exist precisely because markets are irrational. Such
surrender might be merited if the idea of market efficiency was a proven
theory, but it is at best a hypothesis, and at worst a nonscientific assertion.
Why Professors Fly Coach and
Speculators Own Jets
â€śI have made my living from market inefficiency,â€ť so the financier Alfred
Checchi told me during a visit to my Harvard Business School classroom.
Crazy World 53
In contrast, most of the professors at the Harvard Business School are
believers in market efficiency, and one told me (with apparent sincerity)
that technology stocks were not overpriced in 2000.
Although Mr. Checchi is frequently invited to visit the Harvard Busi-
ness School, he is so offended by the assumption of market efficiency
that he refuses to attend finance classes. (Similarly, the Nobel Prizeâ€“
winning economist Professor Ronald Coase told me that his only objec-
tion to the idea of â€śbounded rationalityâ€ť is that the word â€śrationalâ€ť should
not be used in any sentence describing human behavior.)
So who has been more successful in finding market opportunity,
efficiency-preaching professors or irrationality-exploiting financiers? Al-
fred Checchi was able to spend $30 million of his own money on a run
for governor in California. Furthermore, while professors usually fly on
commercial airlines, Alfred Checchiâ€™s success not only provided him
with enough money to buy a private jet, it even allowed him to buy a sub-
stantial stake in Northwest Airlines.
The lesson is that those who seek profit should stop looking for
absolute proof that markets are not efficient. Such proof is not possible.
In contrast, those who seek superior performance should, like Mr. Chec-
chi, accept market irrationality as the first step toward profit.
Furthermore, Mr. Checchi shows that crazy markets donâ€™t have to be
mean. They can, in fact, be very nice. The key is to be on the right side of
irrationalityâ€”to sell at high prices and buy at low prices.
Sell the Fads, Buy the Outcasts
Opportunities occur periodically in many different markets. In all cases,
winning requires a willingness to challenge the conventional wisdom.
During the inflationary 1970s, Andrew Tobias, the personal finance guru,
literally had to deal with a mob in order to profit from an irrationally high
Throughout the inflationary 1970s the price of silver rose by more
54 The New Science of Irrationality
than 1,000% until it exceeded $40 an ounce. At the height of the frenzy,
Tobias decided to sell some of his physical silver. He went to a retail
location that bought and sold precious metals including silver and gold.
As he approached the store he saw a huge crowd and thought it was too
late. Everyone, he supposed, had realized that the price of silver was too
high and had gathered to sell.
When Tobias reached the store he discovered to his delight that the
crowd was gathering to buy! Soon afterwards, silver prices plummeted
and more than 20 years later silver still sells for under $10 an ounce. Sim-
ilarly, in 1970s gold prices soared toward $900 ounce before crashing,
and today it sells for less than half that price.
In the late 1970s precious metals were the investment craze, and they
were terrible investments. In order to profit, Tobias had to lean into the
prevailing opinion by selling while all of those around him were buying.
Usually the mob is not physically present, but rather represented in the
prevailing views of â€śthe knowledgeable.â€ť In 2000, I began dating Bar-
bara. As a joke, I told Barbara that we would have enough money to get
married and have a baby if the stock price of EMC fell from $100 to
below $50 (I was betting against EMCâ€™s stock price by shorting the
Barbara is an archeologist and before this baby challenge she had
never paid any attention to financial media. Now she began to listen, and
the more she learned about EMC, the more she worried. Every single
mention of the stock, in every venue, detailed the virtues of the EMC and
predicted that the shares would continue to rise. Wall Street analysts and
mutual fund managers appeared on TV and described how EMCâ€™s mar-
kets were growing and the stock was a â€śno-brainer,â€ť and a â€śmust own.â€ť
Under the deluge of praise, Barbara asked me what I knew that these
pundits did not. Did I think EMC had bad products? No. Did I have some
inside information that EMC sales were bad? No. Did I know of com-
petitors that would steal EMCâ€™s customers? No. Well, she demanded,
what did I know? I told Barbara that I knew all the analysts and mutual
fund managers loved EMC and that was enough. Barbara responded with
Crazy World 55
â€śthat is so Zen.â€ť With universal praise and love, the stock had nowhere to
go but down, and down it went from over $100 a share to below $4.
The story of precious metals in the 1970s, and EMC more recently,
form a universal pattern. Both Wall Street and Main Street have an amaz-
ing ability to be wrong about investments. At about the same time that
Andrew Tobias was selling silver at ridiculously high prices, unloved
stocks were being sold for rock-bottom prices.
Job Listing: Street Sweeper to Pick Up Surplus
$100 Bills Left Lying in the Street
This is one of the job descriptions that you will never see posted. For
obvious reasons, $100 bills cannot remain visible for long. Because $100
bills tend to get picked up, believers in efficient markets assume that they
canâ€™t exist. An alternative, however, is that there are opportunities to
make profits, but they persist only in what can be thought of as the lizard
brainâ€™s financial blind spots.
Market opportunities will be difficult to find. There are no easy roads
to making money. In The Godfather: Part II, a young Vito Corleone does
the favor of hiding some guns for his neighbor Clemenza (Vito goes on
to become the Don and Clemenza one of his trusted lieutenants). After
the guns are returned, Clemenza says, â€śA friend of mine has a nice rug.
Maybe your wife would like it. . . . It would be a present. I know how to
return a favor.â€ť
As the two men go to pick up the rug from the â€śfriendâ€™sâ€ť house, it
becomes clear that they are actually stealing. In the process, a policeman
comes to the door and Clemenza prepares to shoot the officer. Fortu-
nately, the scene resolves itself without any violence, but the quest for
possessions, whether by legal or illegal means, isnâ€™t an easy one.
While the $100 bills we seek are not easy to find, interestingly some-
times the hardest things to spot are those hiding in plain sight. For exam-
ple, with modern electronic-search capabilities, the FBI can track most
56 The New Science of Irrationality
people down very easily. Special agents enter some information about the
suspect into the computer, click a few keys, and voila, the suspect is found.
Among the hardest to find, however, are people with common names like
John Smith. So one of the few ways left to hide from the FBI is to hide in
plain view, by being part of a crowd. This problem has complicated U.S.
efforts to prevent bombers from boarding planes. There are a large number
of people, for example, with the name Mohammad. Thus, many interna-
tional flights have been cancelled because of mistaken identity.
In the case of markets, the opportunities exist, but the lizard brain is
built not to be able to see them. During the dot-com bubble, the unprof-
itable Internet retailer Etoys was worth more than the profitable, and
much larger, Toys R Us. Recognizing that Etoys was irrationally priced
(and in fact soon went out of business) didnâ€™t require any fancy math.
While profitable investing doesnâ€™t require mathematical prowess, it
does require a willingness to learn about the irrationality in oneself, in
others, and in markets. Becoming a successful investor requires a keen
understanding of human frailty, including oneâ€™s own limitations.
Weâ€™ve encountered many of those limitations in Chapter 2. Two addi-
tional aspects of the lizard brain are harmful to investing success. The
first is our desire to conform, and the second is the fact that our emotions
really do seem to be out of sync with financial marketsâ€”both of which
tend to lose us money.
The Loneliest Man in San Diego
One of our human limitations is the desire to conform to the majority.
This seems to be something built into us and it works against us since
popular investments tend to be unprofitable.
I learned something about this a few years ago at a football game
between my Detroit Lions and the San Diego Chargers. My Lions lost the
game, which was not surprising, as theyâ€™ve had a long tradition of medi-
ocrity. What was surprising was the level of pain that I felt. The game was
Crazy World 57
played in San Diego, and I was almost the only Detroit fan in a sea of
Charger fans. The pain of losing in this setting was far greater than any I
had experienced in home losses.
The human desire to conform to those around us extends beyond
sports stadiums. A line of psychological research performed by Professor
Solomon Asch and others demonstrates the pressure to conform.22 In one
setting for this research, six people enter a room and are asked to answer
a question for which there is a clear answer. For example, here is a refer-
Which of the following lines matches the length of the reference line?
Of the six people answering the questions, five are â€śconfederatesâ€ť of
the experimenter, which means they give false answers designed to
manipulate the behavior of others. In this case, the experimenter first
asks the confederates to rate the lines, and they all give the same wrong
answer. In this case they might say, â€śLine C matches line X.â€ť
After the five confederates have made these obviously false state-
ments, the sixth person (who is not in on the experiment) is asked the
same question. Now this person faces a bit of a quandary. Should he or
she pick the obviously correct answer (A) or pick the same answer as
everyone else (C)? In the original experiments, 75% of subjects some-
times conformed to what is labeled the â€śfalse consensusâ€ť by picking the
obviously false answer (C).
More recently some of these original results have been challenged, but
the basic finding seems intact. We seem built to want to be part of the
crowd, even when doing so contradicts our direct observation.
58 The New Science of Irrationality
In the case of the lines, the correct answer is obvious. In the case of
investments, the correct view is rarely so evident. Consider again the sit-
uation of Etoys versus Toys R Us. While it appears obvious in retrospect
that Etoys would go bankrupt, imagine the pressure to conform. Day
after bubble day, people (many of them professionals) bought the stock at
high valuations. In such cases, our brains seem built to start believing
what others are saying.
To do well, an investor has to purchase exactly that which is unloved.
This requires an ability to take the emotional pain of being different. I
recall my brokerâ€™s mocking laugh when I placed an order to buy Treasury
bonds in early 2000. Bonds had been going down consistently and all the
â€śsmart money,â€ť he said, was selling not buying.
Unlike my Detroit Lions story, the bond story has a happy ending. As
usual, the common consensus was wrong, and the bonds that I bought
soon increased in value. The successful path was the path that was
An Instinct for Losing Money
A cartoon I saw posted over a traderâ€™s desk on Wall Street read, â€śDefini-
tion of a quandary: Should I sit back and watch the market soar or buy
now and cause it to plummet?â€ť
In some areas our natural tendencies take us to good outcomes. My
wifeâ€™s recent pregnancy comes to mind as one such area. During the early
part of pregnancy, the growing fetus is especially sensitive to certain nat-
urally occurring toxins.
According to Margie Profet, who won a MacArthur Foundation
â€śgeniusâ€ť award for her work on this subject, pregnant women are built to
avoid foods that include fetus-damaging toxins (teratogens).23 She pro-
vides evidence that pregnant women are nauseated by such foods, partic-
ularly cabbage-family vegetables like broccoli and cauliflower that have
high levels of damaging compounds. If Profet is correct, then in the area
Crazy World 59
of food choice, pregnant women ought to follow their instincts and eat
whatever tastes good.
When it comes to investing, the message is exactly reversed. The
trades that feel good tend to lead to losses. For example, my older sister
Sue recently sent me an e-mail saying, â€śI have gone crazy buying stocks!
. . . No informed rationale for purchases, just a feeling. Reminds me of
the slots at Vegas!â€ť Sueâ€™s lizard brain was screaming at her to buy.
After almost a year of watching the market rally with only a small
ownership in stocks, sister Sue was fed up. It was time for her to get in on
the gravy train. Unfortunately, this impulsive purchase was timed for
losses. In fact, within a few weeks of the e-mail, the stock market had its
biggest decline in a year.
My buddy Doug had a similar experience recently. Doug appears in a
few chapters of this book and has had excellent results overall (in the
stocks chapter, you can read about the day he earned $500,000 in an
afternoon of surfing). In early 2002, Doug did some careful analysis of a
few firms that he knew well. He decided to buy some Nortel stock at
around $1 a share. This turned out to be a great purchase as the stock
went up steadily.
In the months after Dougâ€™s purchase of Nortel, I heard not a single