The Zany World of Rationality

D<

o YOU remember New Math? Or perhaps you were subjected to it in elementary school. As a popular shorthand term, New Math stood for the revised mathematics curriculum introduced in the 1970s as a reform effort. Supposedly the new program would enable students to understand the meaning behind basic mathematics, rather than just manipulate numbers by rote. That was the theory.

What parents found was that, first, they could no longer help their children with their homework in arithmetic. They just didnt understand it. Secondly, their children werent leaming to add or subtract. They could draw set diagrams, but 2 + 2 wasnt on the teaching agenda. Needless to say, parents shouldered their scythes and pitchforks and headed for the Board of Education, for they held the strange belief that their kids would need to be able to do simple, practical arithmetic.

Now comes the interesting part. The new reforms werent abandoned, but were stirred in with the old practices. Students get a little bit of both. Substitute the efficient market hypothesis for New Math, and you have a pretty good idea of what happened on Wall Street. As we have seen, EMH was a product of academia, but, like the New Math, something went wrong when it left the classroom. None of its prophecies were fulfilled, and its basic teachings were disputed by an increasingly impressive body of evidence.

Despite the steady rain of contradictory evidence, the high priests continued to dismiss, minimize, or trivialize it. All the same, the findings not only questioned the essence of the theory, but also threw down the gauntlet to a major tenet of economics: is man really the rational, almost omniscient creature that he must be in order for the EMH faith to stand? This chapter and the next will delve into that question. The an-

The Former Comrades Meet the Market

Naturally, I would hardly expect you to believe that solid, well-educated American investors could fall prey to such ludicrous behavior. Rather lets tum to the tragicomic events surrounding , the largest investment company in Russia, for an example of how reasonable people go off the deep end when pursuing instant wealth. By 1994, free enterprise and its natural by-product, the urge to get rich quick, had hit Russia with a vengeance. Millions of people from "babushkas" to yuppies

swer will explain why the investment methods I recommend worlc so reliably over time.

Chapter 10 demonstrated the remarkable power of cognitive biases to lead individual investors away from the rational behavior assumed by the theorists and to seduce them into major market errors. Errors so systematic that people aware of them can use the strategies outhned to exploit them with high odds of success.

But theres more. The cognitive biases do not act on individual investors as if each were in a separate cocoon. Heuristic biases have the strength they have demonstrated because humans interact in almost everything they do. Few of us escape the opinions of others. The investment inputs that affect us to a greater or lesser extent also affect the experts we respect, as well as tens of thousands of market participants. In the marketplace then, these biases not only lead investors into errors on their own, but the opinions of others serve to reinforce these mistakes and justify the course we take, no matter how foolhardy it is. As this chapter will demonstrate, there is strong evidence that the power of the group or the crowd, when interacting with the cognitive errors we all fall victim to individually in markets, like dousing flames with kerosene, serve to substantially extend and magnify the blaze.

Observers have watched the absurd behavior of people in market manias or bubbles for hundreds of years. The "Madness of Crowds," "group folly," or "the herd mentahty" have been described in innumerable chronicles. In fact, the market has been an arena where groups or crowds have shown some of the least rational behavior on record, as weU see next. But it is only in the second half of the twentieth century that these behavioral phenomena have been looked at scientifically and psychologists have begun to categorize and analyze them.

Lets begin our study of "rational behavior in markets" by examining the antics of millions of people who first discovered the promise of stocks in the mid-nineties.

* According to Value Line, General Motors has approximately 860,000 shareholders, Exxon has 606,579, and Microsoft has roughly 35,650, for a total of 1,500,000; far less than MMMs reported ownership.

were chasing quick fortunes. Though scores of slick con artists conspired to clip the newest capitalists, no one was better at it than Sergei Mavrodi, the head of . Mavrodi was a promoter par excellence even by the tough standards of westem hype. Spending millions on TV and newspaper advertising, became as well recognized in Russia as Coca-Cola in this country.

Lyonya Golubakov, a fictional shareholder, was as much an icon in Russia as the Marlboro Man is here. Plain-talking, vodka-swilling Golubakov, the protagonist of a major series of television commercials, had found the key to wealth. The polished commercials portrayed him getting rich and fulfilling the Russian dream as would have it. Rolling in mbles from his investment in , Golubakov goes off to San Francisco for a World Cup Soccer game, while his brother can only weep and beat his breast at his lack of foresight in not purchasing the stock. With slick advertising, Golubakov becomes the Russian Horatio Alger.

advertised that it could make its shareholders modestly rich- promising a 3,000% retum annually. It portrayed itself as the vehicle to gain dazzling wealth, creature comforts, and luxurious living. Russian investors swallowed the bait. At its height, had an estimated five to ten million shareholders-more than GM, Microsoft, and Exxon combined.*

What was really? A gigantic pyramid scheme-no more. New stock was sold at the market price, which soared in the first part of 1994. could well afford to redeem the few shares coming in, because thousands of buyers lined up to buy at increasingly higher prices.

What did the company do? When polled, virtually none of the shareholders knew. It had no eamings, revealed no investments, and explained no financial strategy. What investors did know was that its stock skyrocketed and people made fortunes. From Febmary, when the shares were first issued, to July 23, 1994, it was the goose that laid the golden egg. In American dollars, the price rose from $1 to $65. In five months, almost doubled the rise in the Dow Jones in the past 70 years!

Like all good dreams, it had to end. In mid-1994, the Russian Govemment began to investigate . Finding no business of any sort behind the company, it issued wamings to the Russian public. In two days the stock crashed from $60 to 46 cents. As is always the case with bubbles, the aftermath was harsh.