From the March 2009 issue of Boomer Market Advisor • Subscribe!

March 1, 2009

Read yourself to rational behavior

Any good psychiatrist will tell you recognizing destructive behavior is the first step in correcting it. In a slight departure from the normal Checklist format, we highlight seminal works on the topic of irrational investing; behavior that can kill a portfolio. Courtesy Jonah Lehrer of the Wall Street Journal, you'd be wise to recommend them to your boomer clients - and to read them yourselves.

"Extraordinary Popular Delusions and the Madness of Crowds"
By Charles Mackay
1841
Proving "there is nothing modern about financial bubbles" writes Leher, this classic work tops the list. Mackay compiled an exhaustive list of the "schemes, projects and phantasies" that are a recurring theme of economic history. As Lehrer notes, from the tulip mania of 17th-century Holland, in which 12 acres of valuable land were offered for a single bulb, to the South Sea Bubble of 18th-century England, in which a cheerleading press spurred a dramatic spike in the value of a debt-ridden slave-trading company, Mackay demonstrates that "every age has its peculiar folly."

"Judgment Under Uncertainty"
By Daniel Kahneman, Paul Slovic and Amos Tversky
Cambridge, 1982
You'd be hard pressed to find more well-versed experts on the topic of behavioral economics and irrational investing than Daniel Kahneman and Amos Tversky. After developing the concept over a period of decades, the two won the Nobel Prize for Economics in 2002 for their work (Tversky posthumously). As Lehrer notes, it's hard to overstate the influence of this academic volume, which revealed many of the hard-wired flaws that shape human behavior. "In experiment after experiment, the psychologists demonstrated that, unlike the hypothetical consumers in economics textbooks, real people don't treat losses and gains equivalently or properly perceive risks, or even understand the basic laws of statistics - with sometimes severe consequences," Lehrer writes.

"How We Know What Isn't So"
By Thomas Gilovich
Free Press, 1991
According to Lehrer, Thomas Gilovich is an eminent psychologist at Cornell University, "but he is also a lucid writer with a knack for teaching the public about its own mental mistakes." Lehrer relates Gilovich's description of the hot-hand phenomenon in basketball: Most fans are convinced that a player who has made several shots in a row is more likely to make his next shot - he's in the zone, so to speak. But Gilovich, employing an exhaustive analysis of the 1980-81 Philadelphia 76ers, shows this belief is an illusion, akin to trying to discern a pattern in a series of random coin flips and then predicting what the next flip will bring. The same logic also applies to "hot" mutual-fund managers, who are wrongly convinced, along with their customers, that they can consistently beat the market.

"The Winner's Curse"
By Richard H. Thaler
Princeton, 1992
In 2000, the Texas Rangers signed Alex Rodriguez to the richest contract in baseball history after participating in a blind auction. As Lehrer notes, if the team had consulted Richard H. Thaler's "The Winner's Curse," it would have known that such auctions invariably lead to irrational offers - and, indeed, the Rangers' bid (a 10-year contract for $252 million) overshot the next highest offer by about $100 million. According to Lehrer, in addition to documenting how bidders at auctions operate, Thaler - a behavioral economist at the University of Chicago - examines other anomalies, such as the stock market's seasonal fluctuations (nearly one-third of annual returns occur in January) and the surprising unselfishness of people playing economic games.

"Predictably Irrational"
By Dan Ariely
HarperCollins, 2008
Dan Ariely is a mischievous scientist, writes Lehrer: He delights in duping business students, getting them to make decisions that, in retrospect, seem utterly ridiculous. In "Predictably Irrational," which Lehrer refers to as engaging summary of his research, Ariely explains why brand-name Aspirin is more effective than generic Aspirin even when people are given the same pill under different labels (paying more produces the expectation of better results, and the headache complies), and why the promise of getting something without paying for it - such as free shipping, or a free T-shirt if we buy two other shirts - prompts shoppers to spend more money than they would have in the absence of the offer.

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