Betting on Behavior

On a tip from a Fellow Headcase I was told that the excerpt in Vanity Fair from Michael Lewis's new book, The Big Short, was rather tall on psychology. I was skeptical, and not just because my default is skepticism, but also because, like the rest of the universe, I've read quite enough in the past year about the men who either

• caused through greed
• caused through negligence
• caused but somehow didn't suffer from
• supposedly saved us from but weren't wise enough to stop
• profited immensely by

the recent financial crisis.

The protagonist of Lewis's excerpt, Michael Burry, appeared to fall into the final category, if I believed VF's cover line: "The Unknown Genius Who Made a Fortune on Wall Street's Crash." Great. So he's not just wildly wealthy, he's also a genius. And unknown. If he plays blues guitar I'll have to start charging him rent for inhabiting my dreams. I figured the only psychology I was likely to glean from this man's story was some kind of lesson about schadenfreude. Surely this wasn't a largely psychological story told through the guise of the market crash.

This is a largely psychological story told through the guise of the market crash.

While trying not to spoil too many details—in particular Lewis's well-crafted psychological surprise about Burry toward the end of the piece—here are a few parts of the story that triggered my behavioral radar:

The Bubble of Bad Thinking

Way back in May 2003, when many were reading Financial Independence Through Buying And Investing In Single Family Homes (or, in the case of The Headcase, wishing we had enough disposable income just to buy Financial Independence . . . ), Michael Burry recognized that housing markets would tumble by half "if only people became convinced that prices weren't rising," Lewis reports.

We tend to think of the housing bubble as one built on soap, water, and bad investing. People with money tricked people without money into living beyond their means, and as a result our society had a false sense of its worth. But Burry's take is that our bubble wasn't just one of bad investing, it was a bubble of bad thinking. Burry wasn't just betting against housing markets, he was "betting on his theory of human behavior," Lewis writes. It was a very simple theory, really—the kind we all think ourselves able to appreciate, but that few truly see without hindsight: that logical people can make decisions based on highly illogical beliefs.

I suspect this human tendency wouldn't have come as a surprise if I'd read Predictably Irrational: The Hidden Forces That Shape Our Decisions by fellow (and seemingly former) PT blogger Dan Ariely. Instead The Headcase was busy those years watching "The Sopranos," and an episode from this era comes to mind in which Tony tells his son, A.J., something like "Buy real estate. God's not making any more of it." Tony might as well have said, "Steal money. Otherwise you'll have to work for it." I'm stretching a bit, for sure. But looking back, which of these lines were many in this country truly saying circa 2003-05?

When Worldviews Are Threatened

Burry was already a wildly successfully stock manager when he began to bet against subprime loans. Yet when he tried to sell his clients on the novel idea, Burry lost investors. They wondered why Goldman Sachs would sell Burry a bond that was sure to lose them tons of money. It was the ultimate triumph of branding: These smart people trusted the mere name of Goldman Sachs over the reasoning of a man whose portfolios had gone up 242 percent over a period in which broad markets had fallen roughly 7 percent, according to Lewis.

Forced to defend his outlook on the housing market to wary investors, Burry says:

"I hated discussing ideas with investors," he said, "because I then become a Defender of the Idea, and that influences your thought process." Once you became an idea's defender, you had a harder time changing your mind about it.

The line reminded me of a discussion I had a few years back with delightfully coiffed social psychologist Tom Pyszczynski. Pyszczynski co-pioneered a "terror management theory" based on a psychological notion similar to the one Burry presents: when our livelihoods are threatened we lock into our current mindsets, ignore open discussion, and view those with opposing ideas not as different but as enemies.

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Pyszczynski's model is built on a fear of death, but given the importance many place on their vast investments, fear of bankruptcy seems, to me at least, highly relevant. As Pyszczynski put it when we spoke (for this article, though these comments weren't published) in July of 2005:

People who violate our worldview are threatening. ... This is the "mortality salience effect." The general finding is that you cling to cultural values when reminded of death; you view those who uphold your worldview positively, and those who oppose it negatively.

So burrowed were Burry's opponents in their worldviews that when the housing market did burst, and many of them made fortunes, not a single one called Burry to say they had been wrong.

Defined by Disorder

My final point of interest can't be discussed without a moderate spoiler alert, though I'll refrain from revealing too many details. Briefly put, a psychologist diagnoses Burry with a disorder toward the end of Lewis's piece, and his reaction to the new label was quite provocative, and rather touching:

I thought I was different, but this was saying I was the same as other people. ... I thought it was all something special about me. ... Now I was explained by a disorder.

It's a fascinating question of perspective: Is Burry a medical resident thriving on the ability to stay up until 3 a.m. reading about the history of value investing, or is he just another person suffering from a psychological disorder? Berry's thoughts, grounded in feeling yet complex in scope, brought to mind the Headcase's recent discussions about the beneficial role of grief and the upside of depression. Is one person's therapy another person's compromise of character?

So in the end Lewis's story is a crash all right—the tale of a man who made a huge fortune, only to be reduced, in an instant, to asking the questions of purpose that no amount of money can answer—but it's not the crash I thought it would be.