Behavioral finance FAQ / Glossary (Rational)

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Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

(Ir-) Rational, (Ir-) Rationality



 



00/6i,10i - 01/2d,4i,9i,10i,11i,
12i - 02/4i,7i,8i,9i,10i
- 03/5i,
6d,10d,11i  - 03/2i - 04/2i,4i,
5i - 08/2i,12d - 09/1i,11 + see
economic man,
preference,
utility, biases, rationalization,
rational bubble / expectation,
bounded rationality  + bfdef

The quest for rationality has as many pitfalls
as the quest for the Grail. 

If a rational man is one who never shoots at its own foot,
mankind is still waiting to see one.

Tentative definition (general)

Hunting for the optimum food.

A rational behavior (or decision) might be defined as one
that tends to give optimum satisfactions to the

decider.

In that sense, in which rationality is a cousin of wisdom and self-
interest
we follow a rational decision-making process and behave
rationally / wisely
when our decisions and actions have a good chance
to give results which, whenever possible, fit like a glove:

Our scale of preferences (see that word).

Our interests (supposing they differ from our preferences, a tricky
   ethical debate).

Or course that definition is an oversimplification, as seen below. Not 
only it narrowly privileges the self (over other people interest) but
also leaves many ambiguities pending.
At the moment, let us cite only three potential sources of blunders:

Mental conflicts between preferences and interests.

Mental conflicts between immediate and
    long term satisfactions (among them ...survival).

Binary assumptions that the person has the full knowledge
    and ability
needed to understand the situation and anticipate
    its effects, so as to make the right decision.

Classical definition (economy)

Doing things in your best interest

A rational economic decision / behavior is one that has
a good chance to
optimizes one's economic
interests or "utility"
(see that word).

That definition seems more clear-cut than the "general" one above, but
not so much, as "interests" is a vague word and utility has some relations
to preferences.

The rational choice theory (see below) considers rational decisions and
behaviors
as being the usual case among earthlings, at least in economic

matters.

That thesis assumes that everybody makes smart
decisions when its economic interests are at stake.

It also assumes that when everybody takes care of its own interest, instead
of waiting that other people or the society do it, it contributes to a kind of
common economic interest.


Although those stances can be taken as a working hypothesis in
many cases, they are a bit simplistic, not fully ...rational ;-))
.

Definition (irrational)

Flawed decisions for flawed outcomes

A behavior that is deemed irrational is one which outcomes are suboptimal,
or worse, one that goes gravely against one's preferences or interests.

Human behaviors often stray from  wisdom.

Or, to use a less harsh (and binary) wording, they can be

judged as partly rational under the following set of criteria:

We can wonder here about

The degree of counterproductive - even destructive  - effects
    the decision might bring.

The degree of prior knowledge that could have been expected 

from the decider about the probabilities and consequences of its actions.

Like many things, rationality is something relative.

It escapes a too precise definition, a clear benchmark or
gradation enabling to measure it with exactness
and precision.

That is why an academic field of study deals with "bounded rationality"
(see that phrase).

No definition of rational / irrational
     is fully satisfying

Messy rationality, messy reality,
or messy definition?


The definitions given above are based on a rather tautological and reductive
"efficiency" criterion
.

As a first approach, their only advantage is to simplify a quite ambiguous
and fuzzy (see fuzzy logic) philosophical concept.

But actually, no definition in this matter is totally convincing (or
...rational ;-)) as many things interfere:

  

Under that criterion, to evaluate if a decision was wise / rational 
       can o
nly be made ex-post.

Yes, once it is already history!

But, to avoid anachronisms in analyzing how rational it was,
what should
be taken into account are prior objective
probabilities and the fact that some
events could not be
foreseen allowing for this world's fundamental uncertainties
(see
that word).

Ethical decisions cannot be considered irrational,

although they might go against one's interests.

In fact they belong to normal human motivations (see ethic,
fairness).
On the other hand they might obey fanciful "good
intentions"
, or dogmatic and extreme morality, and
generally flawed
ethics.
Then they are in fact irrational.

A tricky case is about how rational are misdeed due to
heinous intentions? They fit their goal, don't they? Is hate
irrational?

I would say so, but ask your usual philosopher!


Some other goals, preferences and supposed

interests might be deemed irrational, however efficient is the
behavior to reach them

This "insane rationality", to use an oxymoron, happens when
those preferences go
against one's "real" interests without true
reason, ethical or otherwise.

Typical cases are addictions and other destructive
    preferences
.

Irrationality can also show its grip when short term
preferences
go systematically against long term ones.


It is not easy to put, for a person or for a decision,
        the cursor
at the right place between

99 % rational and 99% irrational (*)

(*) 100 % hardly exists in our world: see fuzzy logic. This is the

case for rationality as it is for many other things or concepts.

There is rarely full and recurrent rationality or full and
recurrent stupidity.

Well, you might judge that some people strive to reach the
later ;-)

This leads to the crucial notion of
   "bounded rationality"
(see that phrase).


Sometimes irrational is confused with
       emotional.

Emotions (see that word) are normal ingredients in human
decisions and actions

As emotions can easily override logical thinking, thus contribute
to irrationality. Thus the temptation to define "irrational" as
"emotional".
But this also is not so clear-cut. There can be:

Productive emotions: without emotion there are few

motivations to act, and emotions can be positive,

As well as counterproductive ones: when they are illusory,
  
excessive,or plainly negative.


In markets, it is sometimes difficult to judge a general behavior
       as rational or not.

Except when collective madness (or
at least silliness / gullibility) is blatant,
as was the case in
the fully suicidal subprime bubble.

Let us take as an explanation of "rational irrationality", the Keynes'
"beauty contest" (see that phrase) parable.

It shows that the best behavior ...for a while, might be to go 

in the same direction than the market excesses.

In an irrational market, an individual rational
behavior
might be

To imitate the other players,

But to stop doing so before this mimicry
   
(see that word) becomes irrational.

The problem lies in the temptation, hard to resist, to cross
that line between
rational and irrational mimicry. See
below: "rational bubbles".


Many human initiatives that goes against the proven tracks
       might be
considered abusively as irrational.

Truly, many might fail, some even bring havoc.

But without initiatives we would decay and die in the status quo.

The dilemma about "good madness vs. bad madness" is detailed
in the "entrepreneur" glossary article.

What can make a decision irrational?

Recipes for blunders

Irrationality, or "stupidity" to take the common language equivalent,
might have two sides:

1) Irrationality by design or intention
   (deficient or unwise goals):

This occurs when the player's life goals, intentions or preferences
are themselves self-destructive
.

Maybe those goals are not really meant to be suicidal, they might
even have an admirable side. But they might bear anyway the seed
of disaster.

More generally people might determine their goal according to
what they
believe is their interest but which might be against
their real one
.

Also, when a goal, however respectable, overrides everything else,
when the end is
deemed to justify the means, it can become a
destructive fixation, an addiction.

The most striking cases are found in apparently generous dogmas
that in fact bring fanaticism.


2) Operational irrationality (incompetence):

Here, life goals or preferences are constructive (whatever that
means,no way here to give binary definitions).

But the player, when subjected to various cognitive and emotional
biases, although
no doubt exists about the real situation and
the most probable consequences,
is victim of mental biases (see
a section below), or of the uncertainties of the World, and take
unfit tactical decisions that:

* reach those goals only partially and / or in a suboptimal /
   wasteful / 
inefficient way,

* or go against those goals or the intentions behind them.

Also, some apparently efficient means can pervert the goals
(as seen above,the end does not always justify the means)


The border might be fuzzy between those two kind of irrationalities:

Perverse effects can be due to a mix of illusive goals and
operationalamateurism / inefficiency.

Hell is paved with good intentions!

The related mental biases


An irrational (or let us say, counterproductive) decision, whatever its nature
(intentional or practical as seen above), might be caused by:

Cognitive biases: having to do with flawed memory, logical fallacies...

Or emotional biases: excessive love, hate, greed, fear, social
   pressure... Emotions play a big part in human decisions, consciously

or unconsciously

Or biased automatic reflexes and routines (automaticity bias),

Here, cognition and emotion are not really involved, as the neural
autopilot took over.

Those biases affect each of the two main steps of a decision (see
decision making):

1) The observation and understanding of the situation,

2) The application or optimization of preferences when making
     the decision.

See also "bounded rationality"

Rational bubble, expectations, bias

Rational choice theory

See the related page
    of the Glossary

Rational ignorance

08/3i + see ignorance, cognitive
overload, (bounded) rationality,

(near) rationality

(bounded) Rationality

(near) Rationality

See the related page
of the Glossary
 

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This page last update: 03/07/15   

 
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