5 Books That Explain Investor Psychology

The most remarkable breakthrough in personal finance in the past 20 years is identifying the reasons we are so poorly programmed for investing. Interest in the fields of behavioral finance, investor psychology and neuroeconomics (how the brain works when we make financial decisions) is exploding -- as is the number of books on those subjects. Here’s a selection of my favorites.

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, by George A. Akerlof and Robert J. Shiller (Princeton University Press, 2009; $25 for hardcover).

This timely tome offers a powerful explanation of how emotions and psychology influence the big financial and economic picture. The authors deftly pick apart the failings of traditional economics and show how we ignore issues such as trust, overconfidence and fear at our peril, and they suggest ways to prevent ourselves from being our own worst enemy. Shiller, a Yale economics professor, is best known for his bestseller, Irrational Exuberance. Its first edition, published in 2000, called the Internet bubble. The 2005 edition warned of the housing bubble and its dangers. Coauthor Akerlof is a Nobel Prize–winning economist.

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Nudge: Improving Decisions About Health, Wealth and Happiness, by Richard H. Thaler and Cass R. Sunstein (Penguin, 2008; $16 for paperback).

Cleverly written and refreshingly readable, Nudge is a guide about how our psychological quirks and predispositions affect our decisions about “health, wealth, and happiness.” The book’s focus is on policy -- how good choices by companies and governments can help us make better decisions. Thaler is one of the nation's top authorities on investor psychology, and Sunstein is President Obama's "regulation czar."

Your Mone & yYour Brain: How the New Science of Neuroeconomics Can Help Make You Rich, by Jason Zweig (Simon & Schuster, 2007; $15 for paperback).

Of the books about investor psychology and neuroeconomics, journalist Jason Zweig's was the first comprehensive treatment for the lay investor, and it is still the best. He has spoken to or had his brain scanned by everyone who counts in the field, and he puts all of it in the book (which, unfortunately, goes on a few dozen pages more than it should).

Inside the Investor's Brain: The Power of Mind Over Money, by Richard L. Peterson (Wiley, 2007; $60 for hardcover, but available on Amazon.com for $38).

Although this book is more scientific and less anecdotal than Your Mone & yYour Brain, it is still clear and accessible. The author is a psychiatrist and former futures trader who trains professional investors to overcome their bad habits and who runs a hedge fund based on investor behavior (he pretty much bets on the opposite of investor sentiment).

How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life, by Thomas Gilovich (The Free Press, 1993; $19 for paperback).

While this book isn’t about investing per se, it’s easy to apply its lessons to your portfolio. You’ll learn why we make broad assumptions based on a small amount of data, how statistics lead to ridiculous conclusions and why we so often build a case for what we wish were true.