What is 'Rational Behavior'
A rational behavior decision-making process is based on making choices that result in the most optimal level of benefit or utility for the individual. Most conventional economic theories are created and used under the assumption all individuals taking part in an action/activity are behaving rationally. Rational behavior does not necessarily always involve receiving the most monetary or material benefit because the satisfaction received could be purely emotional.
BREAKING DOWN 'Rational Behavior'While it is likely more financially lucrative for an executive to stay on at a company rather than retire early, it is still considered rational behavior for her to seek an early retirement if she feels the benefits of retired life outweigh the utility from the paycheck she receives.
Rational behavior within the economy is a portion of behavioral finance that focuses on the behavior of individuals within the marketplace. For a decision to be deemed rational, it must make logical sense, and often the decision is made without significant emotional response over the choice. Rational behavior does not necessarily require a person to attempt to get the highest return as it does allow for the consideration of risk. A person’s aversion to risk may be considered rational at multiple levels depending on her exact goals and circumstances.
While most models assume rational behavior on the part of consumers and investors, behavioral finance also substitutes the idea of “normal” people for perfectly rational ones. It allows for issues of psychology and emotion, understanding these factors alter the actions of the investors, leading to decisions that may not be entirely rational or logical in nature.
Rational and Irrational Decision-Making
For a choice to be deemed rational, it must often remove any and all emotional components from the decision-making process and focus solely on the facts as they are presented. Even with emotion removed, more than one determination for a situation may be deemed rational as long as it can be logically explained. One such decision could involve whether to place funds in one bond or another if they both hold similar rates of return and have similar maturity dates.
In contrast, behavioral finance also analyzes irrational behavior on the part of the investor. This can include making decisions based primarily on emotional components, such as investing in a company the investor has positive feelings for even if financial models suggest the investment is not wise. Further, the disposition effect, or the failure to sell stock that has begun to fall, can also be considered irrational.