The Wall Street Journal

I've got a short column in the Wall Street Journal today where I recommend five books on human irrationality. I wanted to work in a novel too, but I soon realized that every novel is about irrational people.

1. Extraordinary Popular Delusions and the Madness of Crowds
By Charles Mackay
1841

There is nothing modern about financial bubbles. In this classic work, Charles Mackay compiled an exhaustive list of the "schemes, projects and phantasies" that are a recurring theme of economic history. 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." He notes that even the most intelligent investors are vulnerable to these frenzies of irrational exuberance: Isaac Newton is reported to have lost a small fortune after the South Sea Co. went bust.

2. Judgment Under Uncertainty
By Daniel Kahneman, Paul Slovic and Amos Tversky
Cambridge, 1982

It's hard to overstate the influence of this academic volume, which revealed many of the hard-wired flaws that shape human behavior. For one thing, authors Daniel Kahneman, Paul Slovic and Amos Tversky -- all of them psychologists -- almost single-handedly dismantled the assumption of "rational man," which had been the standard view of human nature since Plato. 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. For example, the failure of many investors to properly weigh losses -- people are irrationally loss averse -- makes these investors much more likely to sell stocks that have gone up in value. This leads, over time, to a portfolio composed entirely of shares that are declining in value, which is why the stocks that these investors sell tend to significantly outperform the stocks that they keep.

3. How We Know What Isn't So
By Thomas Gilovich
Free Press, 1991

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. Consider 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 that 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.

4. 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. 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. 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. When given $10 and told to share the money with someone else, most people don't keep it all, or even most of it. Instead, they tend to split the cash equally, which is neither selfish nor rational. As Thaler notes, people have a powerful instinct for generosity, which can lead them to do things that flagrantly violate the model of Homo Economicus.

5. Predictably Irrational
By Dan Ariely
HarperCollins, 2008

Dan Ariely is a mischievous scientist: He delights in duping business students, getting them to make decisions that, in retrospect, seem utterly ridiculous. In "Predictably Irrational," an 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. (In other words, we go broke trying to save a buck.) In one of his most famous experiments, Ariely showed how exposing people to a few random digits can later dramatically influence how much they bid for wine: Higher numbers lead to higher bids. The lesson, Ariely says, is that the rational brain is a feeble piece of machinery.