The second thing is overconfidence. Well, you can just do survey. Most people think they're above average. Most people think they're a better driver than the average person. Most people think if they tried hard, they would be a better investor than the average person. Most people think they understand something that are not widely understood. Wishful thinking bias is actually a term used in the psych literature that people overestimate the probability of the things that they identify with and want to see happen. Very simple, you ask people what they think the probability of their team winning is. And it's always higher if it's their team or a political candidate. So this wishful thinking bias also helps explain the immense volume of trade in financial markets. There's so many shares traded every day that it seems a puzzle. Why would people need to change their holdings so often? Well it must be because of wishful thinking bias. There's also a tendency for overconfidence in friends and leaders. Well I say here the central bankers tend to be, thought to be a genius. Throughout history, they're always geniuses until they mess up maybe, but there's also overconfidence in your own friends. You tend to think that your own friends are really smarter than average, it's not just you. Anyone you identify with, you tend to be overconfident in. So, there was a book by Rakesh Khurana, at the Harvard Business School, that documents the way CEOs, Chief Executive Officers, are chosen by corporations. Now companies will bring in a CEO from another company, that was a success, to transform their own company. And pass over someone in their own company who knows the business really well, and has been there 30 years, and might well be promoted up to CEO. But they'll take in someone from another company that was a success there, without regard for the fact that it was probably mainly luck that this person was a success. And they'll put him in in place of their own guy, and then he feels that he has to make some transformation. He's supposed to be a genius, they're paying him $50 million. So he does some dramatic things and totally destroys the company, because he doesn't know what he's talking about. Also, Nassim Taleb in his book Fooled by Randomness, which is another great book to read, describes how people in business are overly influenced by the random successes of themselves or others. People are over, now Irving Fisher was a professor here at Yale. And he wrote a book, he was writing a book in 1929 about how the stock market will continue to make us richer and richer. But the crash interrupted his book, so he had to change the title of the book. So he called it The Stock Market Crash and After. But what he said is the stock market crash of 1929 is a terrific buying opportunity. I was right all along, the stock market will just keep going up, or at least stay at a quote, permanently high plateau. He ultimately borrowed money to try to stay in the market. He borrowed money from his relatives, he lost everything. He lost his house, he had no place to live. His house is right near here on Prospect Street. It was, they tore it down, it's gone. Yale had to give him a place to live. But he never gave up, he kept saying that the stock market will keep going up. Why do people do this? Well this is overconfidence, and he's a great speaker. But he wasn't a great stock market forecaster. Cognitive dissonance, this is a term used by social psychologists. It refers to the mental conflict that occurs when one's beliefs are discovered to be wrong. So I'll give you a famous experiment that revealed cognitive dissidence. The experimenters went to get a list from car dealers of people who had just bought a new car. They knew that the person had bought a new car and they knew what model it was. They then didn't tell the subjects how they had found them, and they asked them, what magazines do you read?. And when they named the magazine, they would pull out a copy, they had all the new magazines there and say, lets go through the magazine. And you tell me which ads you read in the magazine and also whether you thought about them and read them carefully. So, what do you think people did? Did they read ads for the car they just bought? Yes, they did that strongly. They read and reread and congratulated themself about how great a car it was. Do you think they read the ads of a car that they, a different make of car, that they were thinking of buying but did not buy? As you expect, no, they don't read those ads. So why are they doing, isn't this irrational behavior? You've already bought the car, why bother to read any ads? But on the other hand, why would you selectively ignore the ads for the other cars? You're just trying to make yourself feel good, right? And so, it's irrational behavior. Once you've made a decision, you kind of identify with that decision and it's me. Now I want to hear more about why I was right. I don't want to hear that I might be wrong. It's a personal thing, this isn't really talking about being embarrassed by a bad decision. It's just perfectly internal to you that you just get a bad feeling when you made a mistake. So the disposition effect might also be partially explained by that. If you bought a stock and its price goes down, you're feeling that maybe you were wrong and that gives you a cognitive dissidence. So you just avoid it, I'm not going to think about that stock, I didn't buy that, I'm not here. And then, until it goes up, if it goes back up, then you might sell it as soon as it comes back. So Will Goetzmann here at Yale with Nadav Peles looked at mutual fund investors. These tend to be small retail investors and they found evidence for cognitive dissonance, basically the disposition effect. But they also found that when they talked to investors, they didn't even remember the performance of funds that had declined. So there's a tendency of human thought because of cognitive dissonance, just to blank out your bad memories of times when you were wrong, and don't even know that they happen. We live in an economy that incentivizes people to capitalize on your psychological quirks. And they strongly incentivize people to do that. That's what the profit motive is all about. >> So, do you think that we're not rational with these quirks, or would you agree that most people are rational? >> Well, yeah, we're not rational. I'm not rational, I don't know about you. We're not rational in the sense that we have some consistent logical way of deciding things. We all make little mistakes and we learn, by the way, we hear from others about when they were really taken advantage of so we avoid some things, some gimmicks. And we have laws against them. The government regulates lotteries, you can't start a lottery. You can't do it at all, or maybe you could do it as part of a state government. And that's because they know that there are lots of giveaway contests, but they don't charge, because it's illegal to charge for them. They can just use them as publicity. So we have a legal system that protects us against our own psychological failings.
