" ... the reason [for the inherent instability of the financial system is] human behaviour. As we have seen in recent months, all financial institutions are at the mercy of our innate tendency to veer from euphoria to despondency; our recurrent inability to protect ourselves against what the statisticians call “tail risk” (rare but high-impact events in the “tails” of the bell-shaped curve that plots events according to their frequency); above all, our perennial failure to learn from financial history. In a famous article, Daniel Kahneman and Amos Tversky demonstrated with a series of experiments the tendency that people have to miscalculate probabilities when confronted with simple financial choices. First, they gave their sample group 1,000 Israeli pounds each. Then they offered them a choice between either a) a 50 per cent chance of winning an additional 1,000 pounds or b) a 100 per cent chance of winning an additional 500 pounds. Only 16 per cent of people chose a); everyone else (84 per cent) chose b). Next, they asked the same group to imagine having received 2,000 Israeli pounds each and confronted them with another choice between either a) a 50 per cent chance of losing 1,000 pounds or b) a 100 per cent chance of losing 500 pounds. This time the majority (69 per cent) chose a); only 31 per cent chose b). Yet, viewed in terms of their payoffs, the two problems are identical. In both cases you have a choice between a 50 per cent chance of ending up with I,OOO pounds and an equal chance of ending up with 2,000 pounds (a and c) or a certainty of ending up with I,500 pounds (b and d). In this and other experiments, Kahneman and T versky identify a striking asymmetry: risk aversion for positive prospects, but risk seeking for negative ones. A loss has about two and a half times the impact of a gain of the same magnitude. This 'failure of invariance' is only one of many heuristic biases (skewed modes of thinking or learning) that distinguish real human beings from the homo oeconomus of neoclassical economic theory, who is supposed to make his decisions rationally, on the basis of all the available information and his expected utility. Other experiments show that we also succumb too readily to such cognitive traps as: 1. Availability bias, which causes us to base decisions on information that is more readily available in our memories, rather than the data we really need. 2. Hindsight bias, which causes us to attach higher probabilities to events after they have happened (ex post) than we did before they happened (ex ante). 3. The problem of induction, which leads us to formulate general rules on the basis of insufficient information. 4. The fallacy of conjunction (or disjunction), which means we tend to overestimate the probability that seven events of 90 per cent probability will all occur, while underestimating the probability that at least one of seven events of 10 per cent probability will occur. 5. Confirmation bias, which inclines us to look for confirming evidence of an initial hypothesis, rather than falsifying evidence that would disprove it. 6. Contamination effects, whereby we allow irrelevant but proximate information to influence a decision. 7. The affect heuristic, whereby preconceived value-judgements interfere with our assessment of costs and benefits. 8. Scope neglect, which prevents us from proportionately adjusting what we should be willing to sacrifice to avoid harms of different orders of magnitude. 9. Overconfidence in calibration, which leads us to underestimate the confidence intervals within which our estimates will be robust (e.g. to conflate the ‘best case’ scenario with the ‘most probable’). 10. Bystander apathy, which inclines us to abdicate individual responsibility when in a crowd. If you still doubt the hard-wired fallibility of human beings, ask yourself the following question. A bat and ball, together, cost a total of £1.10 and the bat costs £1 more than the ball. How much is the ball? The wrong answer is the one that roughly one in every two people blurts out: 10 pence. The correct answer is 5 pence, since only with a bat worth £ 1.05 and a ball worth 5 pence are both conditions satisfied.
If any field has the potential to revolutionize our understanding of the way financial markets work, it must surely be the burgeoning discipline of behavioural finance. It is far from clear how much of the body of work derived from the efficient markets hypothesis can survive this challenge. Those who put their faith in the 'wisdom of crowds' means no more than that a large group of people is more likely to make a correct assessment than a small group of supposed experts. But that is not saying much. The old joke that 'Macroeconomists have successfully predicted nine of the last five recessions' is not so much a joke as a dispiriting truth about the difficulty of economic forecasting. Meanwhile, serious students of human psychology will expect as much madness as wisdom from large groups of people. A case in point must be the near-universal delusion among investors in the first half of 2007 that a major liquidity crisis could not occur.
" Excerpted from the Afterword of The Ascent of Money by Niall Ferguson. Pg. 344-347. You can find it on Amazon http://www.amazon.com/Ascent-Money-Financial-History-World/dp/1594201927 | 
