Are Investors Rational – Probably Not?

Allow me to preface my comments with the following – I usually do not give out investment advice, however, periodically an article comes along that needs to be read.

Are investors rational? Probably not. If you don’t believe this statement than explain to me why it makes good financial sense to buy a house in today’s market. If they are not rational can they be taken advantage of by people who understand this? What do you think?

Based on e-mails and comments I received recently, there are a lot of questions about how rational the stock market is given housing crash, capital markets, slowing consumer spending, etc. The article below from Market Watch asks the same question. In addition, the article has suggested reading on behavior finance and neuroeconomics. If you believe there is a difference between smart money and the rest of us, or you are afraid of the effects of the increasing power of “black pools”, you may want to read some the suggested books before dropping a pile of money into the market.

Want to learn how to harness your brain power and get rich? Well, folks, there are two basic minicourses covering the mysterious world of the investor's brain, also known as behavioral finance or neuroeconomics or just plain investment psychology.

Here are the two courses: First for beginners: "Behavioral Finance 101: The Myth of the Rational Investor." Second, the graduate level course, "Behavioral Finance 602: The Secret to Beating America's 95 Million Irrational Investors."

Take one course or both. Your choice will depend on how you answer this quirky question: "Can you fix a broken machine with broken tools?" Stick with me because your answer will reveal your chances of becoming one of America's 8 million millionaires.

First off, here's Course 101 in a nutshell, using a key passage from Money magazine columnist Jason Zweig's brilliant new book, "Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich:"

"Your brain is a superbly functioning machine, steering you away from danger while guiding you toward basic rewards like food, shelter and love ... But that brilliant machine can lead you astray when it comes to investing. You buy high only to sell low. You try to time the market. You follow the crowd. You make the same mistakes again. And again. How come?"

Stop. Notice two crucial neuroeconomics definitions: First, your brain is a "machine." Second, when investing, your brain is a "broken machine."

That's right, your brain is a saboteur. So the goal of Course 101 is fixing your broken machine (your brain). Warning: The saboteur remains, so you end up with a "less-broken machine," not a rational investing "machine." Why? Because your emotions run the rational brain. At best, you're a little "less irrational," but not rational.

Investors place too much faith in neuroeconomics. As Zweig points out, this new science gained credibility when Princeton University psychologist Daniel Kahneman won the Nobel Prize in Economics five years ago. Today neuroscience is "making stunning discoveries about how the brain evaluates rewards, sizes up risks and calculates probabilities."

Actually, Kahneman and other neuroscientists have been making discoveries for several decades, disproving Wall Street's bogus "rational investor" theory, Zweig says ,thanks to:

"The wonders of imaging technology [with which] we can observe the precise neural circuitry that switches on and off in your brain when you invest. Those pictures make it clear that your investing brain often drives you to do things that make no logical sense, but make perfect emotional sense."

Today experts looking at brain-images see that "your brain has only a thin veneer of modern, analytical circuits that are often no match for the power of the ancient parts of your mind."

When you invest "you stir up some profound emotions," and "understanding how those feelings -- as a matter of biology -- affect your decision-making will enable you to see as never before what makes you tick, and how you can improve, as an investor."

In a nutshell that's Course 101: Once you realize what "makes you tick" you will behave "less irrational" and become a rich investor. The goals of Course 101 are: (1) Become fully aware of your sabotaging behavior; (2) Follow neuroscience's new rules; (3) Behave "less irrational;" (4) Make more money playing the market.

And so, dear students, I urge you to round out your understanding of Course 101 by reading these works:

• "Investment Madness," by Prof. John Nofsinger (2001) of Washington State University, a behavioral-finance guru who has written several key books on the field including, "The Psychology of Investing," a widely used textbook for professionals, and "Investment Greed," about the stock market scandals and others.
• "Mind Over Money," by John Schott (1998), a Harvard Medical School psychiatrist, behavioral-finance expert and portfolio manager.
• "Investment Therapy," by Richard Geist (2003), another Harvard Medical School psychiatrist and president of the Institute of Psychology and Investing.
• "Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing" (2000), by Prof. Hersh Shefrin of the Santa Clara Business School, also editor of the three volume collection "Behavioral Finance."

Now for the second course: "Behavioral Finance 602: The Secret to Beating America's 95 Million Irrational Investors." The popular text is Yale economist Robert Shiller's "Irrational Exuberance," which was published just as the 1990s insanity peaked and collapsed into a three-year bear/recession.

Shiller says "irrational exuberance" is "wishful thinking on the part of investors that blinds us to the truth of our situation." And you can't "fix" it. Bull/bear cycles will forever drive markets to extreme highs (greed) and extreme lows (fear). Why? Because emotions, not rational behavior, drive Main Street investors.

We'll never become "less irrational" because trying to fix a "broken machine" with neuroscientific rules is a "wishful thinking" strategy, to use Shiller's description.

So now you know how neuroscience differs in 101 versus 602. Neuroscience is a "broken tool" when used to help individual investors become "less irrational," the goal of 101. However, neuroscience is an extremely powerful tool when used by Wall Street insiders (bankers, portfolio managers, brokers, quants and their friends) as a weapon against America's 95 million investors, to manipulate, dominate and control them. Shiller puts it in simple terms: "Deep down, people know that the market is highly priced, and they are uncomfortable about it. Most people I meet ... are puzzled ...We are unsure whether the market levels make any sense. ... We are unsure whether the high levels of the stock market might reflect unjustified optimism, an optimism that might pervade our thinking and affect many of our life decisions. We are unsure ..."

Flash forward. Today, Shiller sees the cycles of greed, fear, overoptimism and panic again peak and collapse in the recent housing/credit bubble. Endless cycles of irrational exuberance will repeat again and again and again, ad infinitum. Why? Because investors really don't want to or cannot fix their broken machines.

But there is an even more sinister reason 101 doesn't work. And that's also the force driving "Behavioral Finance 602. Get this: Wall Street's insiders have been "taking" Course 101 for decades. They already know America's irrational investors will never become "less irrational."
Instead, hotshot neuroeconomists are developing computer models describing the irrational behavior of irrational investors. And they're using knowledge to their advantage. As University of Chicago behavioral finance guru Richard Thaler says: Wall Street "needs investors who are irrational, woefully uninformed, endowed with strange preferences, or for some other reason willing to hold overpriced assets."

So the new gurus of behavioral finance who invented Course 602 are now working for Wall Street insiders against Main Street's irrational investors, and making big bucks. They want investors to stay irrational. They have no intention of helping investors become "less irrational."

They are using their new strategies and technologies to map out the behavior "coordinates" of irrational investors, so they can attack like a stealth bomber under the radar and take full advantage of irrational investors. Want more? Read all about how neuroeconomists are beating America's gene pool of 95 million irrational investors in:

• "Capital Ideas Evolving," by Peter Bernstein
• "Mean Markets and Lizard Brains," by Terry Burnham
• "Fooled by Randomness," by Nassin Nicholas Taleb

Discover the magic of Course 602, if you build a career on it you'll be on your way to becoming a multimillionaire early. Learn the basics in Course 101 and maybe you'll become millionaire by the time you retire, maybe.

I am currently in the process of reading "Fooled by Randomness" and it is the best book I have read on the stock market since "Random Walk Down Wall Street".