Warren Buffett gives us some introductory remarks on why even smart people get bad results:
"It's ego. It's greed. It's envy. It's fear. It's mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it's not because we're so smart, it is because we're rational and we very seldom let extraneous factors interfere with our thoughts. We don't let other people's opinion interfere with it... we try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people's behavior. And those are the factors that cause smart people to get bad results.
I always look at IQ and talent as representing the horsepower of the motor, but then in terms of the output, the efficiency with which the motor works, depends on rationality. That's because a lot of people start out with 400-horsepower motors and get a hundred horsepower of output. It's way better to have a 200-horsepower motor and get it all into output. So why do smart people do things that interfere with getting the output they're entitled to? It gets into the habits, and character and temperament, and it really gets into behaving in a rational manner. Not getting in your own way."
Buffett's partner at Berkshire Hathaway, Charlie Munger says, "If you want to avoid irrationality, it helps to understand the quirks in your own mental wiring and then you can take appropriate precautions." Since human beings are wired with psychological limitations, the more emotional, confused, uncertain, insecure, excited, distracted, tired or stressed we are, the easier we make mistakes.
And remember geniuses aren't excluded. Even Isaac Newton got caught up in the South Sea mania and invested a big chunk of his fortune. Interestingly, he pulled out early (after making a respectable 7000 pounds) then went back in after the bubble continued to inflate. The inevitable bust happened and he lost 20,000 pounds – a considerable sum at the time. As a result of this crisis, he stated “I can calculate the motions of heavenly bodies, but not the madness of people."
Newton was so furious about South Sea that nobody even dared to talk about this in front of him in his life time.
Mark Twain made a substantial amount of money through his writing, but he lost a great deal through investments, mostly in new inventions and technology, particularly the Paige typesetting machine. It was a beautifully engineered mechanical marvel that amazed viewers when it worked, but was prone to breakdowns. Twain spent $300,000 (equal to $7,590,000 today) on it between 1880 and 1894, but before it could be perfected, it was made obsolete by the Linotype. He lost not only the bulk of his book profits but also a substantial portion of his wife's inheritance.
How come these smart people be so wrong? Charlie Munger, the prodigious partner of Warren Buffett at Berkshire has the answer: ... they don't do what I'm telling you to do - which is to take all the main models from psychology and use them as a checklist in reviewing outcomes in complex systems.