This paper was prepared for John B. Taylor and Michael Woodford, Editors

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According to the American Psychiatric Association’s DSM–IV (1994), “Most individuals with

Pathological Gambling say that they are seeking ‘action’ (an aroused, euphoric state) even more than

money.  Increasingly larger bets, or greater risks, may be needed to continue to produce the desired

level of excitement” (p. 616).

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loving behavior.  Friedman and Savage (1948) proposed that the co-existence of these

behaviors might be explained by utility functions that become concave upward in extremely

high range, but such an explanation has many problems.  For one thing, people who gamble

do not appear to be systematically risk seekers in any general sense, instead they are seeking

specific forms of entertainment or arousal.

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  Moreover, the gambling urge is compart-

mentalized in people’s lives, it tends to take for each individual only certain forms:  people

specialize in certain games.  The favored forms of gambling tend to be associated with a sort

of ego involvement: people may feel that they are especially good at the games they favor

or that they are especially lucky with these.

The complexity of human behavior exemplified by the gambling phenomenon has to be

taken into account in understanding the etiology of bubbles in speculative markets.

Gamblers may have very rational expectations, at some level, for the likely outcome of their

gambling, and yet have other feelings that drive their actual behavior.  Economists tend to

speak of quantitative “expectations” as if these were the only characterization of people’s

outlooks that mattered.  It is my impression, from interviews and survey results, that the

same people who are highly emotionally involved with the notion that the stock market will

go up may give very sensible, unexciting, forecasts of the market if asked to make

quantitative forecasts.

The Irrelevance of History

One particular kind of overconfidence that appears to be common is a tendency to believe

that history is irrelevant, not a guide to the future, and that the future must be judged afresh

now using intuitive weighing only of the special factors we see now.  This kind of

overconfidence discourages taking lessons from past statistics; indeed most financial market

participants virtually never study historical data for correlations or other such statistics; they

take their anchors instead from casual recent observations.  Until academic researchers

started collecting financial data, most was just thrown away as irrelevant.

One reason that people may think that history is irrelevant is a human tendency toward

historical determinism, a tendency to think that historical events should have been known

in advance.  According to historian Florovsky (1969, p. 364):

In retrospect we seem to perceive the logic of events, which unfold

themselves in a regular order, according to a recognizable pattern, with an

alleged inner necessity, so that we get the impression that it really could not

have happened otherwise.

Fischhoff (1975) attempted to demonstrate this tendency towards historical determinism

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This feeling can of course be disrupted, if a sudden event calls to mind parallels to a past event,

or if the social cognition memorializes and interprets a past event as likely to be repeated.

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by presenting experimental subjects with incomplete historical stories, stories that are

missing the final outcome of the event.  The stories were from historical periods remote

enough in time that the subjects would almost certainly not know the actual outcome.

Subjects were asked to assign probabilities to each of four different possible conclusions to

the story (only one of which was the true outcome).  There were two groups of subjects, one

of which was told that one of the four outcomes had in fact happened.  The probability given

to the outcomes was on average 10% higher when people were told it was the actual

outcome.

Fischhoff’s demonstration of a behavior consistent with belief in historical determinism

may not demonstrate the full magnitude of such behavior, because it does not capture the

effects of social cognition of past events, a cognition that may tend to remember historical

facts that are viewed as causing subsequent historical events, or are connected to them, and

to forget historical facts that seem not to fit in with subsequent events.  It will generally be

impossible to demonstrate such phenomena of social cognition in short laboratory

experiments.

A human tendency to believe in historical determinism would tend to encourage people

to assume that past exigencies (the stock market crash of 1929, the great depression, the

world wars, and so on) were probably somewhat known in advance, or, at least, that before

these events people had substantial reason to worry that they might happen.  There may tend

to be a feeling that there is nothing definite on the horizon now, as there presumably was

before these past events.

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  It is in this human tendency toward believing history is irrelevant

that the equity premium puzzle, discussed above, may have its most important explanation.

People may tend just not to think that the past stock market return history itself gives any

indication of the future, at least not until they perceive that authorities are in agreement that

it does.

According to the representativeness heuristic, discussed above, people may see past

return history as relevant to the future only if they see the present circumstances as

representative in some details of widely remembered past periods.  Thus, for example, the

public appears to have made much, just before the stock market crash of 1987, of similarities

in that period to the period just before the crash of 1929.  Newspapers, including the Wall

Street Journal on the morning of the stock market crash of October 19, 1987, showed plots

of stock prices before October 1929 superimposed on a plot of stock prices before October

1987, suggesting comparisons.  In this way, historical events can be remembered and viewed

as relevant, but this is not any systematic analysis of past data.

Lack of learning from historical lessons regarding financial and economic uncertainties

may explain why many investors show little real interest in diversification around the world

and why most investors appear totally uninterested in the correlation of their investments

with their labor income, violating with their behavior one of the most fundamental premises

of financial theory.  Most people do not make true diversification around the world a high

priority, and virtually no one is short the company that he or she works for, or is short the

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