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This is a separate page of the R section of the Glossary
Behavioral finance FAQ / Glossary (Rational expectation)
Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed, i: incidental
See the related page in the glossary
01/12i - 02/1i,4i,9i,10i - 03/10i- 04/8i,0i
- 05/11i - 08/2i + see expectations, cascades,
mimicry, greater fool, trend, utility + bfdef2
Are there such things as rational frenzies?
Should we use them or escape them?
The rational choice tenet
Are we interested by our ...interest?
There is / was the idea among some
"classical" economists
that people usually take theireconomic decisions in a
a rational way, in which they are supposed to:
* analyse objectively the economic situation and prospects
* and serve their interest (what is called their "utility" see that word).
This "rational choice" (see that phrase) or "rational expectations" tenet
is one of the assumptions behind the "market efficiency" (see that phrase).Behavioral economics / behavioral finance findings show instead that people suffer individual
and collective behavioral biases (see that phrase), which lead to a "bounded rationality".
This article takes the examples of trend following and market exuberance
market exuberance, what is rational?
Or is it a bias due to pure emotional herding?
Or delusions?
crashes this herd behavior might lead to?
Better be crazy with the
Binary questions usually lead nowhere.
We could better use gradual / fuzzy logic, a practice you often see in this site.
Then, the answer to the above questions about the rationality / irrationality
of a trend-following strategy (notably in financial matters, but also inordinary life) based on group / crowd mimicry
is that it is:
1) Partly rational,
2) In other words it fits a "degree of rationality",
which evolves with the circumstances,
3) And that it can easily become irrational.
A case by case approach, keeping one's eyes open is needed.
Expecting rational money?
One thing to observe, for example, is that usually, when there is a market bubble,
many experts deny there is one and give plenty ofrationalization (see that
word) to stress their point.This is often a sign that they themselves caught the disease.
The rational side of
being a (trend / bubble) follower
The irrational side of
being a (trend / bubble) followe
Trends (see that word) are market phenomena
that tend to persist, a dent in the random walk
hypothesis.
specifically the bubble-playing one, might
work for a time for the players.
While being conscious of the risks
involved, they might believe they will be able
to leave the game early enough when it turns
bad.As the addict says! "I can stop tomorrow".
The follower strategy might be labeled
over-rationality / rational bias / greater
fool rational delusion.
When too many people adopt it, the
market enters pricing excesses, such
as bubbles (*) and crashes.
often overlooked, is that the
turning point comes with aliquidity squeeze that blocks
the exit from the game
Why not be generous and take the
exit from the mad pasture,
leaving some good or bad grass on the field
for other crazy beasts who want it so much?(*) Bubbles (see that word) might be called rational at their start (see cascades).
But usually after a while there is no more rational thinking behind them, they become fads
due to herding.
Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed, i: incidental
See EMH, utility, preference,
economic man, rationalThe rational choice economic theory is the main foundation of the EMH
(efficient market hypothesis, see that phrase).In its most glorified version, the idea is that...
...all of us are well informed and emotionless geniuses
...our economic decisions are about always the best.
To take an humbler version, that theory supposes that
economic agents, as a whole and most of the time, decide
and act
in the fashion of the "economic man" (see that phrase).
In other words the theory assumes that their decision making process in economic
areas is working:
anticipations(see rational expectation).
attitude, linked to their own economic situation),
Here, rationality is taken in a narrow monetary sense, not taking into account
other preferences,
of preferences.
But it is far from proven that economic agents obey such criteria; behavioral biases are
all over the place.
