How to Profit From Irrational Investors -- Which is Almost Everybody

(MoneyWatch)  Investors like to think of themselves as logical beings who act in consistent ways to maximize wealth. Isn't that what the field of economics is built upon?

Well, people do act in consistent ways. Unfortunately, those ways happen to be predictably irrational and ignore simple common sense. Let's look at some of the facts:

• More money pours into the stock market just after it hits new highs and out of the market in times like these, after it has its "half-off" sale.
• Investors throw their money at whatever is currently hot. Right now, it's gold. In 2007, it was China and India. Money flows into whatever has been hot.
• It's common knowledge that costs and taxes take from returns, yet most investors are willing to pay an "expert" in the unshakable belief that one need only find the right investment, or the right investment adviser, to outsmart capitalism.

According to the Monte Carlo simulation model I built for my book How a Second Grader Beats Wall Street, investors play a game with their financial freedom that they have less than a 0.1 percent chance of actually winning versus the low-cost, common-sense approach. Why do they behave that way? It could have something to do with three forces at play:

1. Ourselves. Are humans thinking beings who happen to feel or feeling beings who happen to think? When I ask people what money means to them, I get responses such as "freedom, security, survival, and enjoyment." These are all emotional words, so it borders on delusional to think that logic alone is driving our decisions. In reality, fear and greed lead the typical investor around by the nose, and make them do some pretty crazy things. Investors are now more likely to consider themselves risk-averse than they were in 2007, when the market was reaching new highs. There are many ways that we trick ourselves that I'll explore in future columns.
2. The Financial Services Industry. No one understands the irrational investor better than the industry I work in. We are always coming out with new products such as the AAA-rated insured sub-prime investment that can deliver high returns without much risk. In good times, we know how to take advantage of your greed. In bad times, we profit from your fear. That's how we roll.
3. The Media. There has never been more good financial journalism than there is today. Yet too much "financial porn" is still out there because that's what most people want. Investors are eager to know what the next hot stock is going to be and the gurus are happy to oblige. Knowing what the market is going to do over the next year is their gig, right? Well, not so much. Ever wonder how many gurus predicted this half-off stock market sale in October of 2007, when the market was at its height? Nearly everyone was predicting the past, just as they're doing now.

Emotions make people invest in what can only politely be termed as an irrational manner. It is the human condition to be hard-wired to do dumb things with our nest eggs, and it's not the world's best kept secret either. The financial services industry, and much of the media, know this and play investor emotions like a violin.

Future columns will show you what to look for to avoid these predictable mistakes. I'll also show you how to profit from the mistakes of others convinced that they're acting as logical, rational, beings.