If there is one lesson that we should have learned from the recent financial crisis, it is that none of us are as rational as we'd like to think we are. By assuming that economic actors are homo economicus, modern financial theory has always ignored the elephant in the room that is irrational behavior. That's an odd omission. After all, psychologists and marketers have long known that as patients and consumers, humans are far from rational. In hindsight, it seems absurd that modern finance -- the entire intellectual architecture upon which Wall Street's risk-taking culture is based -- assumes that we are rational investors when we are anything but.

The Irrational Investor: What You Know Isn't So

Assuming that we are rational may flatter our egos, but it is wishful thinking at best. Einstein was wrong when he declared compound interest to be "the most powerful force in the universe." It's just that even Einstein's remarkably evolved mammalian brain had trouble absorbing its remarkable implications. Homo economicus -- the hero of modern finance -- would not have had that problem.

It's hard to admit that we are irrational because so much of our experience in the real world seems to contradict it. Consider the notion of "hot hands" or "streaks" in sports. in "hot hands" or "streaks" in sports. You've probably seen an athlete "on a roll"-- a basketball player who hits shot after shot. And there is little that anyone could say to convince you that streaks are just a figment of your imagination. Yet, that's exactly what Tom Gilovich, a psychologist at Cornell, did in the early 1990s when he proved conclusively that "hot hands" in basketball is a statistical mirage. Such was the level of disbelief that a small army of academics spent the next decade trying to disprove Gilovich's conclusions by parsing statistics across a wide range of sports. Turns out that only one streak in professional sports cuts the statistical mustard as the real deal: Joe DiMaggio's 56-game hitting streak in 1941. All other streaks in sports can be explained by mere chance.

Our irrationality extends into the realm of social and cultural values. If you are like most people, you instinctively believe that "the more choice you have, the better." But consider an activity as straightforward as buying jeans. Today, there are so many fits and styles of jeans available that buying a simple pair of blue jeans (at least for men) has become just plain annoying. Ditto for the bevy of financial products, whether mutual funds, insurance or mortgages. And if you are a senior citizen who has tried to wade through the dozens and dozens of options offered by Medicare Part D for prescriptions drugs, you know better than most that the mantra of wide choice is both confusing and stressful. Is it any wonder that you behave irrationally in the infinitely more complicated world of investments?

The Irrational Investor: The Death of Homo Economicus

For all its whizz-bang equations that make economics seem like a hard science, economics and modern financial theory are based on some pretty flimsy foundations. Nobel Prize-winning pundit Paul Krugman recently noted that the last 20 years of macroeconomics has been a complete waste of time. Thus, the new-found popularity of psychologically-based disciplines like behavioral economics.

The sudden realization that humans aren't wired like the hyper-rational Vulcan Mr. Spock of Star Trek fame has led to the emergence of a new form of public policy named "libertarian paternalism." Pioneered by University of Chicago academics Richard Thaler and Cass Sunstein (now at Harvard) in Nudge: Improving Decisions About Health, Wealth, and Happiness, libertarian paternalism recognizes the economic actors as humans and not homo economicus. Consider their (partial) explanation for the recent financial crisis. Not having PhD level financial skills, most humans were unable to understand the increasingly complex mortgage products that were being sold to them. Having bitten into the apple back in the Garden of Eden, humans were unable to resist the temptation of dessert cart-style "teaser rates." And succumbing to the financial fear and greed assumed away by financial economists, humans could not ignore the collective irrationality of the belief that real estate prices would go up forever. Admirably, the authors fess up to having made no better decisions in their own lives than your average human. But, as misery loves company, they also point out that even Nobel prize-winning economists don't behave rationally. After all, how did Harry Markowitz, another University of Chicago economist who won the Nobel Prize for developing the "efficient market frontier" invest his own retirement funds? He split them 50:50 between stocks and bonds.

Thaler and Sunstein recommend setting up the "choice architecture" across a wide range of human activities to influence you to make better choices. They thereby take Robert Cialdini's "Psychology of Persuasion" into the realm of public policy. Put fruits and vegetables at the front of the cafeteria line and you encourage healthy eating. This type of thinking is the impulse behind requiring restaurants in New York to highlight the number of calories for each dish on their menus. Seems like a good idea -- as long as you trust the government to play the role of your personal trainer.

The Irrational Investor: Lessons for Investing

It took the business schools and the CFA Institute two generations to have modern finance come to dominate Wall Street thinking. But it took less than two years for the assumptions behind it to collapse. And it's no surprise that neither of the world's most successful investors -- Warren Buffet or George Soros -- have any more use for the efficient market frontier than its Nobel Prize-winning founder Harry Markowitz did. Both Buffett and Soros instinctively recognized the importance of irrationality in financial markets to their success. Buffett actively exploits "Mr. Market's mood swings" while Soros' approach has always been market psychology masquerading as philosophy.

The lesson to take away is simple. Understand that because you are irrational, many of your financial decisions will be wrong. But it's your willingness to admit that you are an irrational investor that is your greatest (and rarest) strength. It will make getting rid of your losers and adding to your winners that much easier. That willingness alone will put you streets ahead of Wall Street's wizards of modern finance.

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