Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ … Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

—Warren Buffett

The third discipline through which we evaluate financial booms and busts is psychology. We can gain a fresh perspective by focusing on actual, rather than theoretical, human behavior. One of the key underlying assumptions of most economic lenses is that humans are rational individuals. Although the term rational is one that might be interpreted in many ways, it generally refers to profit-maximizing, self-interested, and optimized decision-making. According to such “rational choice” logic, humans accurately weigh costs and benefits to make the most economically rewarding decisions.

The framework of rational choice and rational action theories has had a dominating influence over most of the social sciences in recent years, stemming in large part from the success it achieved in influencing the economics discipline. According to John Scott at the University of Essex, “what distinguishes rational choice theory is that it denies the existence of any kinds of actions other than the purely rational and calculative.”1 In fact, rational choice logic goes further to describe individual preferences in terms of utility functions—functions that are transitive (i.e. if A is preferred to ...

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