The History of Behavioral Finance: From Tulip Mania to Prospect Theory

Chapter 2 of Pompian’s book is basically a history lesson. But here’s the thing: it is a surprisingly interesting one. Because when you trace where behavioral finance came from, you realize that humans have been making the same stupid money mistakes for centuries.

Tulips, Status, and Selling Your House for a Flower

The chapter opens with tulip mania, probably the most famous example of irrational investor behavior in history. In the 1600s, a guy named Conrad Guestner brought tulip bulbs from Constantinople to Holland. Tulips were beautiful, rare, and became an instant status symbol for rich Dutch people.

So here’s what happened. First the wealthy bought tulips because they liked flowers. Then speculators jumped in to make money. Then the middle class started selling their homes, livestock, and everything else to buy tulip bulbs. At the peak, one bulb was worth as much as a team of oxen or a major piece of furniture. They even set up tulip exchanges and hired tulip notaries to record transactions. Actual laws were written to regulate tulip trading.

Then in 1636, some speculators started selling. Prices dropped slowly at first, then crashed. Within a month, bulbs lost 90% of their value. People who mortgaged their homes for flowers were ruined.

Does this sound familiar? Dot-com bubble? Housing crisis? Crypto? The specifics change but the pattern stays the same. People get excited, pile in, prices go crazy, and then everything crashes. We have been doing this for 400 years and we still have not learned.

Adam Smith Was a Psychologist First

Most people know Adam Smith as the “invisible hand” guy from The Wealth of Nations. But Pompian points out something many people miss. Smith’s earlier and more important work was actually The Theory of Moral Sentiments from 1759. That book was all about psychology: pride, shame, vanity, insecurity.

Smith wrote about how rich people love their wealth not because of what it buys but because it makes others pay attention to them. And poor people are ashamed of poverty not because they lack stuff but because they feel invisible. This is from 1759. It sounds like it could be a social media psychology paper from last week.

The point is that the original father of economics understood that money decisions are deeply emotional. It was later economists who stripped all the psychology out and replaced it with math.

How Economics Lost Its Mind (Literally)

In the 1870s, the neoclassical economists showed up. Jevons, Menger, Walras. They wanted economics to be a proper science, with equations and models. So they invented Homo economicus, the rational economic man. This imaginary person makes perfect decisions based on perfect information with perfect self-interest.

The model is elegant. It makes the math work. But here’s the problem: it describes nobody who has ever lived.

Keynes, Veblen, and others pushed back with the idea of “bounded rationality.” Real people are somewhat rational, but limited by what they know and how their brains work. They cannot calculate optimal outcomes for every decision. They take shortcuts. They go with “good enough.” This is closer to how actual humans operate.

The Experiments That Changed Everything

The middle part of this chapter gets into experimental economics, and it is genuinely fascinating. In 1931, a researcher named Thurstone asked people to choose between bundles of hats, coats, and shoes. He wanted to see if real people’s choices matched the theoretical “indifference curves” that economists drew on blackboards. Turns out, sort of yes but also sort of no.

Later, researchers Rousseas and Hart made people choose between different combinations of bacon and eggs for breakfast (and you had to eat whatever you picked, no saving leftovers). This was a more realistic test, and it showed that real choices were messy and hard to aggregate into clean mathematical models.

Then came Maurice Allais with his famous paradox. He gave people two sets of choices involving probabilities and payoffs. Mathematically, if you pick option A in the first set, you should also pick option C in the second set. But most people picked A and then D, which contradicts expected utility theory. This was a big deal because it showed that the core mathematical model of rational decision-making just does not describe what people actually do.

Kahneman and Tversky: The Real Founders

Here is where the chapter gets really good. In the late 1960s, two psychologists named Daniel Kahneman and Amos Tversky started studying how people make decisions under uncertainty. Their 1979 paper “Prospect Theory: An Analysis of Decision under Risk” is basically the founding document of modern behavioral finance.

Prospect theory says that people evaluate gains and losses differently. The pain of losing $100 feels much worse than the pleasure of gaining $100. This is called loss aversion, and it explains so many bad investment decisions. People hold onto losing stocks too long because selling would mean admitting a loss. They sell winners too early because they want to lock in the gain.

Here is one of their classic experiments from the chapter. They gave one group this choice: you have $1,000, and you can either take a sure $500 more, or flip a coin for $1,000 more or nothing. 84% took the sure thing.

Another group got this: you have $2,000, and you can either lose $500 for sure, or flip a coin to either lose $1,000 or lose nothing. 69% chose the gamble.

The math is identical in both cases. You end up with the same expected value. But people are risk-averse when it comes to gains (give me the sure thing!) and risk-seeking when it comes to losses (let me gamble to avoid the loss!). This is not rational. But it is very, very human.

Putting People in Boxes (In a Useful Way)

The last part of the chapter covers psychographic models. These are systems for classifying investors by personality type.

Barnewall’s model from 1987 is simple: you are either a passive investor (inherited wealth, more security-focused) or an active investor (earned your own money, higher risk tolerance, wants to be in control). It is basic but it works as a starting point.

The BB&K model from 1986 is more detailed. It classifies investors along two axes: confident vs. anxious, and careful vs. impetuous. This gives you five types:

• The Adventurer puts it all on one bet, hard to advise, volatile
• The Celebrity follows the crowd, afraid of missing out, easy prey for brokers
• The Individualist does their own research, careful and analytical, the dream client
• The Guardian older, worried about preservation, wants guidance
• The Straight Arrow balanced, average, middle of the road

I recognize people I know in each of these categories. I am probably some mix of Individualist and Guardian myself. The practical value here is obvious: if you know what type of investor you are, you can watch out for the specific mistakes your type tends to make.

Pompian also mentions his own classification system called behavioral investor types (BITs), which he covers later in the book. The general idea is the same: know thyself, and you will make fewer dumb money mistakes.

What I Take Away

This chapter is dense with history, but the lesson is clear. Humans have always been irrational with money. The economists who tried to pretend otherwise built beautiful theories that do not describe reality. And the psychologists who finally said “let’s just study what people actually do” created something genuinely useful.

The next chapter gets into the specific biases themselves, which is where things get really practical.

Previous: What Is Behavioral Finance?

Next: Introduction to Behavioral Biases

This is part of a series retelling “Behavioral Finance and Wealth Management” by Michael M. Pompian. Start from the beginning.