Behavioral finance FAQ / Glossary (Rational expectation)

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This is a separate page of the R section of the Glossary

 

Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

(Ir-) Rational, (Ir-) Rationality

See the glossary's related page

Rational bubble,
   expectations, bias


01/12i - 02/1i,4i,9i,10i - 03/10i -
04/8i,0i - 05/11i - 08/2i
+ see
trend, cascades, expectations,
mimicry, greater fool, 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?

The idea among some "classical" economists
was that people usually take their economic
decisions in a a rational way
, thus 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" or "rational expectations" or
"economic man"
tenet is one of the assumptions behind
the "market efficiency"
(see those phrases in the glossary)

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

In case of   market exuberance,
    what is rational?

Is it always foolish to follow a folly?


Is it rational to participate in exuberant decisions, together
  
with most other investors? 

Or is it a bias due to pure emotional herding?

Are those investor expectations (see expectation, beauty

   contest...) rational? Or delusions?

When nearly everybody does the same, can we call
   "rational"
the bubbles and
crashes this herd behavior might
     lead to?

Following the frenzy consciously:
     at the fringe of rationality?

Better be crazy with the crazies?


Binary questions usually lead nowhere.

We could better use gradual / fuzzy logic, as often seen in this
site.

Then, the answer to the above questions on how rational /
irrational is a trend-following strategy (notably in financial
matters, but also in ordinary 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.

How this works in investment matters

Expecting rational money?

One thing to observe, for example, is that usually, when a
market bubble is in the making, many experts deny there is one.

They use  rationalization (see that word) to stress their
point.

=> This is often a sign that they themselves caught the disease.

Rational side 

 Irrational side 

of trend / bubble) following

 Trends (see that word) are
  market price orientations that

  tend to persist, a dent in the
  random walk hypothesis.

  Thus a trend-following 
     
strategy, specially the
     
bubble-playing one,
     
might work for a time
      for the
players.

While being conscious of
the risks involved,
they

might believe to be able to
leave the game early enough
when it turns bad.
As the addict hopefully says!
"I can stop tomorrow".

  A follower strategy might 
  be called over-rationality
/
  rational
bias / greater fool
  rational delusion.

When too many people
adopt it, the market enters
pricing excesses, such as
bubbles (*) and crashes.

Trend followers 
  
overlook often the
   danger that the  

turning point comes
with
a liquidity
queeze
that
blocks
the game exit.

Why not be generous and take
the
exit
from the mad pasture,
leaving a few good or bad
grass for other crazy
cows that 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 caused by herding.

 

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

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

Rational choice theory

See EMH, utility, preference,
economic man, rational

The "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 smartly in their own interest

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 on the basis of :

a good knowledge of the situation and of consistent anticipations

 (see rational expectation).

the players' economic utility (their risk vs.reward

attitude, linked to their own economic situation),

Here, rationality is taken in a narrow monetary sense, not taking
into account other preferences or lower / higher purposes.

Or at least, to take a broader approach) their scale / hierarchy

of preferences.

But it is far from proven that economic agents obey such criteria;
behavioral biases are all over the place.

Rational ignorance


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

(bounded) Rationality

(near) Rationality

Due to their lengths, those
    articles are in
a separate page

of the "R"glossary section

(*) To find those messages: reach that Behavioral-Finance group and, once there,
      1) click "messages", 2) enter your query in "search archives".

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This page last update: 21/08/15  

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