Book of the week: why markets act irrationally

Book review: The Behavioral Investor It's widely accepted that markets and individual investors don’t always act rationally. Daniel Crosby tries to explain why.

The Behavioral Investor

Daniel CrosbyHarriman House (£25)

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If you've ever followed the ups and downs of the stockmarket you'll know that markets and individual investors don't always act rationally. Indeed, sometimes their behaviour can be completely irrational.

Daniel Crosby tries to explain why. Building on decades of research, he gives the reader a crash course in the developing science of behavioural finance.He looks at the reasons for our collective financial irrationality, and how the average person can become a better investor by recognising poor decision-making in themselves and taking advantage of it in others.

Hobbled by evolution

The book is divided into four sections spread over 16 chapters. The first three chapters look at the biological causes of human irrationality, rooted as it is in our evolutionary need to be part of a wider group and the way that our brains are wired to make quick decisions.

The next part examines how ego, conservatism, attention and emotion can affect our investing. Then Crosby discusses how you can start to change your investing behaviour. In the final four chapters he gives some explicit guidance that can help you build an efficient portfolio, as well as develop a more systematic process for investing.

The author is a professional psychologist who has written extensively about the lessons his field holds for personal finance. He is therefore able to provide a huge amount of information about the latest studies in this area. He also has a knack for telling stories that grab the reader's imagination, beginning with the opening chapter, set in the aftermath of a plane crash. This storytelling ability is important because, as he points out, studies have shown that humans tend to pay more attention to information that is conveyed as part of a story rather than just as raw data.

The only downside is that Crosby seems more interested in the behavioural side of things than in the financial implications, especially in the first two-thirds of the book. In the earlier chapters, his advice boils down to just two main pieces of advice: be less risk-averse and don't diversify your portfolio too much. However, towards the end of the book he makes up for this by addressing a broader range of topics, such as value investing, fund management and momentum. Those impatient for immediate advice might want to read the final section first.

Overall, this is a good introduction to the topic, especially for those who find the current books on offer either lacking in detail or too dry.At the very least, it should open your eyes to the extent that apparently intuitive behaviour can be deeply flawed.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri