Against the Gods: The Remarkable Story of Risk

Chapter 17

The Theory Police

Investors must expect to lose occasionally on the risks they take. Any other assumption would be foolish. But theory predicts that the expectations of rational investors will be unbiased, to use the technical expression: a rational investor will overestimate part of the time and underestimate part of the time but will not overestimate or underestimate all of the time—or even most of the time. Rational investors are not among the people who always see the glass as either half empty or half full.

Nobody really believes that the real-life facts fit that stylized description of investors always rationally trading off risk and return. Uncertainty is scary. Hard as we try to behave rationally, our emotions often push us to seek shelter from unpleasant surprises. We resort to all sorts of tricks and dodges that lead us to violate the rational prescriptions. As Daniel Kahneman points out, “The failure of the rational model is not in its logic but in the human brain it requires. Who could design a brain that could perform the way this model mandates? Every single one of us would have to know and understand everything, completely and at once.”1 Kahneman was not the first to recognize the rigid constraints of the rational model, but he was one of the first to explain the consequences of that rigidity and the manner in which perfectly normal human beings regularly violate it.

If investors have a tendency to violate the rational model, that model may not be a very ...