rom the infamous Dutch tulip hysteria of the 17th century to the Great Depression to the dot-com crash, wild bouts of speculation have occasionally inflated big fat financial bubbles that soaked investors when they burst. Daniel Kahneman, a professor at Princeton who was the first psychologist to win the Nobel in economics (which he was awarded last year for studies he conducted with Amos Tversky), has attributed market manias partly to investors' ''illusion of control.'' Kahneman recently explained the basic weirdness of the dot-com bomb to The Financial Times: ''A high percentage of investors knew it was a bubble and still invested because they thought they could get out in time.'' Why did so few heed the alarms? According to Kahneman's ''prospect theory,'' most of us find losses roughly twice as painful as we find gains pleasurable. This radical precept subverts much of ''utility theory,'' the longstanding economic doctrine that says we weigh gain and loss rationally. When combined with the reality that some market winners display the same recklessness as some victorious gamblers -- a phenomenon that Richard Thaler, an economist at the University of Chicago, calls ''the house-money effect'' -- the market is often revealed to be downright loony. Indeed, the findings of ''behavioral finance'' in recent years have increasingly challenged the fundamental rationality assumed by defenders of ''efficient markets,'' those who believe Eugene Fama's famous dictum that prices ''fully reflect available information.'' Fama, another economist from the University of Chicago, is saying that you can't get ahead of the market by building a clever model, because you can't predict the news that will affect prices. (As for the crazy players, Fama has contended that big-time rational arbitrageurs counterbalance them.) So, as stocks have shown some new life this spring, can you put your trust back in the market?
A fairly straight line of standard economic theory runs from the late 1700's to the 20th century. First came the ''invisible hand'' that Adam Smith said guided decision-making according to basic market logic. This was refined in the early 19th century by Jeremy Bentham into a philosophy of utilitarianism that assumed, among other things, that consumers knew what was best for themselves. John Maynard Keynes challenged some of that doctrine's underpinnings during the 1930's, when he compared market participants to viewers trying to guess the outcome of a beauty contest. Milton Friedman subsequently helped rescue rationalism during the post-World War II period, arguing that most market participants behave as if they had made rational calculations, even if they were not consciously making those calculations. In 1979, however, Kahneman and Tversky published a paper that included results from subjects who answered two comparative money problems. And their responses appeared to reveal systematic deviations from rationality: In problem No. 1, subjects were given an imaginary $1,000 and asked to choose between (a) a 50 percent chance to gain $1,000 and a 50 percent chance to gain nothing and (b) a sure gain of $500. In problem No. 2, subjects got $2,000 and were asked to choose between (a) a 50 percent chance to lose $1,000 and a 50 percent chance to lose nothing and (b) a sure loss of $500. The results? In the first problem 84 percent chose (b). In the second, 69 percent chose (a). What's odd here is that if the majority opt for the $1,500 of (b) in problem No. 1, the majority therefore ought to take the same $1,500 payout in answer (b) in the second problem. But instead the majority is willing to take the risk to try to ''break even'' when the problem is framed in terms of losses. Irrationally, people feel differently about losing than they do about gaining, even if either choice produces the same outcome.
Hedging the Theories, or Practical Advice
The Princeton economist Burton Malkiel, whose investing classic, ''A Random Walk Down Wall Street,'' has just come out in its eighth edition, mostly touts efficient markets. Like Fama, he says he believes that prices tend to go up over time but without any discernible pattern that can be used to predict future movements. Unlike Fama, however, Malkiel concedes that bursts of market irrationality do occur, which is why he calls himself ''a random walker with a crutch.'' ''There are lots of good lessons to be taken from behavioral finance,'' Malkiel says. ''But what it doesn't do is provide any kind of clear road map for cool sharp-penciled professionals to beat the market. For example, the existence and extent of bubbles are only discernible in retrospect.''
Interestingly, irrational- and rational-market experts provide much the same advice for investors: buy into index funds that are pegged to broad swaths of the market rather than trying to play selected sectors. Then hold. You might expect that advice from the efficiency mavens, but how do the behaviorists -- who say you should be able to exploit the crazy market players -- square that conservative circle? ''While behaviorists think that it is theoretically possible to beat the market,'' Richard Thaler says, ''individual investors do not have the time or training to do that on their own, and finding superior skills among active mutual-fund managers is not easy, either. So a reasonable strategy to adopt is to settle for the average returns and low fees offered by index funds.''
An existentialist corollary for your consideration. More than a few philosophers have sermonized that behaving as if an afterlife exists is beneficial to society in the here and now, even if the belief turns out to be unfounded. Now listen to Malkiel: ''To the extent that the behaviorists are right, few if any could take those insights and beat the market. In other words, you ought to act as if the markets are efficient.''
Volatility vs. Craziness
From ''The New Financial Order: Risk in the 21st Century,'' by Robert J. Shiller, Princeton University Press, 2003
''Despite the volatility we observe in speculative markets, no one should conclude from any of my or others' research on financial markets that these markets are totally crazy. I have stressed only that the aggregate stock market in the United States in the last century has been driven primarily by psychology and fads, that it has shown massive excess volatility. But many markets for subindexes relative to the market do not show evidence of excessive volatility, and the market for individual stocks shows substantial evidence supporting the notion that prices in these markets do carry genuine information about future fundamentals. A second problem is that financial innovation sometimes encourages secret dealings, deception and even fraud. . . . But this should not be viewed as evidence against impressive progress in the field of finance.''
Of Higher Interest
• Kahneman, D., and Tversky, A. ''Prospect Theory: An Analysis of Decision Under Risk,'' Econometrica, Vol. 47, pp. 263-292 (1979).
• Malkiel, B.G. ''A Random Walk Down Wall Street.''
• Fama, E.F. ''Market Efficiency, Long-Term Returns and Behavioral Finance,'' Journal of Financial Economics, Vol. 49, pp. 283-306 (1998).
• For less empirical market studies, on film, see also Oliver Stone's ''Wall Street'' and John Landis's ''Trading Places.''
Dirk Olin is national editor at The American Lawyer.