Irrational Everything

Prof. Daniel Kahneman has dozens, perhaps hundreds, of stories about people's irrational behavior when it comes to making economic decisions. It's no wonder, because for dozens of years he and his late colleague Amos Tversky researched human behavior. Many of their studies concerned the making of financial decisions.

But the story Kahneman recalls when asked about the economic models at the root of the current financial crisis is actually taken from history, not an experiment. It concerns a group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.

They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, "We suddenly found a map." The officer looked at the map and said, "You found a map, all right, but it's not of the Alps, it's of the Pyrenees."

According to Kahneman, the moral of the story is that some of our economic models, perhaps those of the investment world, are worthless. But individual investors need security - maps of the Pyrenees - even if they are, in effect, worthless.

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Daniel Kahneman: Master of the imperfect mind

It isn't often that a psychologist helps explain personal finance, but Daniel Kahneman isn't an ordinary psychologist. In 2002 he won a Nobel Prize in economics for his research into how people confront uncertainty.

Raised in France and Israel and formerly a professor at the Hebrew University of Jerusalem, UC-Berkeley and Princeton, Kahneman has spent half a century studying how the human mind works - or fails to.

Just retired at age 73, Kahneman is now writing a book about decision-making in collaboration with Money Magazine's Jason Zweig. The two recently chatted on the record.

Q. Are people rational?

A. Economists argue that people are rational - that they use all available information to make decisions and that those decisions are consistent over time. Psychologists say that is totally unrealistic. Economists think about what people ought to do. Psychologists watch what they actually do.

Q. Such as?

A. How people respond to a risk depends partly on how it is described. An investment said to have an 80% chance of success sounds far more attractive than one with a 20% chance of failure. The mind can't easily recognize that they are the same.

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