The Undoing Project

Behavioral Finance
By
Sarah F. Roach, Vice President

While it’s hard to imagine a riveting book about the collaboration between two academics, such a book has just been published.  The Undoing Project by Michael Lewis, author of recent bestsellers The Big Short and Moneyball, is the story of the Israeli professors who pioneered the concepts underlying behavioral psychology and behavioral economics:  Daniel Kahnemann and Amos Tversky.

In Moneyball, Lewis wrote about baseball executives clinging to conventional methods of selecting players despite the demonstrated ineffectiveness of their techniques.  But he didn’t ask why they clung to their ways.  Only later did he learn that humans systematically and predictably cling to irrational, even counter-productive, behavior in many things.  In fact, over the past 40+ years, traditional psychology and economics have undergone seismic changes in pursuit of explanations for irrational behavior.  The fields now known as behavioral psychology and behavioral economics grew from the work of these two remarkable men.

Kahnemann, a French Jew, fled the Nazis with his mother during World War II and eventually settled in Israel.  Life had taught him to be secretive, careful and slow to trust.  In contrast, Amos Tversky, native Israeli and brilliant, was brash and self-confident to the point of arrogance.  “Danny was always sure he was wrong.  Amos was always sure he was right.”  And yet when they discovered each other at Hebrew University in the late ‘60s, unprecedented theories about human decision-making and behavior poured out of their collaboration.

The psychological and economic theories prominent in the 1960s assumed that humans act rationally, like “decent intuitive statisticians.”  It was thought that people could judge probabilities and act accordingly—notwithstanding occasional mistakes based on emotion.  From hours of private conversation, Tversky and Kahnemann devised ingenious experiments that demonstrated not only the inaccuracy of “rational man,” but the fact that behavior could be predictably wrong.  An example is “the gambler’s fallacy,” illustrated by this expectation:  If a coin lands on heads several times, it’s more likely to land next on tails.  They wrote, “Even the fairest coin, given the limitations of its memory and moral sense, cannot be as fair as the gambler expects it to be.”   Not only did research subjects not act like statisticians, subjects who were statisticians made the same mistakes!

Lewis writes extraordinarily well—weaving engrossing biographies of both men with comprehensible summaries of the concepts they developed and the unfolding reaction in both psychology and economics.  He includes stories about economists, psychologists, physicians and even a basketball executive who independently went in search of more accurate theories about human behavior.  To quote Lewis about the basketball general manager, frustrated at the ineffectiveness of player recruitment, “It was as if he had been assigned to take apart a fiendishly complicated alarm clock to see why it wasn’t working, only to discover that an important part of the clock was inside his own mind.”  When he unearthed Kahnemann and Tversky’s work, he began to fix the clock.  Younger psychologists and economists have taken it convincingly into the mainstream.  I highly recommend this fascinating book, because understanding key psychological concepts is critical to successful investing.