Loading the player...

What is 'Rational Behavior'

Rational behavior refers to a decision-making process that is based on making choices that result in the optimal level of benefit or utility for an individual. The assumption of rational behavior implies that people would rather be better off than worse off. Most conventional economic theories are based on the assumption that all individuals taking part in an action or activity are behaving rationally.

BREAKING DOWN 'Rational Behavior'

More than one behavior in a given situation may be deemed rational, as long as it can be logically explained. In addition, rational behavior may not involve receiving the most monetary or material benefit, because the satisfaction received could be purely emotional or non-monetary.

Individualized Rational Behavior

Rational behavior does not necessarily require a person to attempt to get the highest return; the optimal benefit for an individual may involve non-monetary returns and/or risk considerations. For example, 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. Further, a person’s aversion to risk may be considered rational at multiple levels depending on the exact goals and circumstances. For example, an investor may choose to take more investment risk in his own retirement account than he would in an account designated for his children's college education. Both would be considered rational choices for this investor.

Behavioral Finance

While most conventional economic theories assume rational behavior on the part of consumers and investors, behavioral finance is a field of study that substitutes the idea of “normal” people for perfectly rational ones. It allows for issues of psychology and emotion to enter the equation, understanding that these factors alter the actions of investors, and can lead to decisions that may not appear to be entirely rational or logical in nature. This can include making decisions based primarily on emotion, such as investing in a company for which the investor has positive feelings, even if financial models suggest the investment is not wise.

For example, an individual may choose to invest in the stock of an organic produce operation rather than a conventional produce operation if he or she has strong beliefs in the value of organic produce, even if the present value of the organic operation compared to that of the conventional operation indicates the conventional operation should earn a higher return. Behavioral finance attempts to model behaviors that on the surface appear irrational.

RELATED TERMS
  1. Rationalization

    Rationalization is a reorganization of a company in order to ...
  2. Behavioral Economics

    Behavioral Economics is the study of psychology as it relates ...
  3. Rational Expectations Theory

    The rational expectations theory posits that individuals make ...
  4. Behaviorist

    A behaviorist accepts the often irrational nature of human decision ...
  5. Emotional Neutrality

    Emotional neutrality is the concept of removing greed, fear and ...
  6. Behavioral Modeling

    Behavioral modeling means using available and relevant consumer ...
Related Articles
  1. Investing

    Don't Let Emotions Derail Investment Decisions

    Understanding behavioral finance can help you make better investing decisions.
  2. Managing Wealth

    The Science of Making Better Investment Decisions

    Neuroeconomics attempts to bridge neuroscience, cognitive psychology and economics in order to understand the mechanisms underlying economic decision making.
  3. Investing

    Why Rational Ignorance About Your Investments Might Really Be OK

    It's impossible to know everything about the markets. Find out how ignorance affects your investments.
  4. Investing

    Behavioral Finance and the 4 Stages of Bull and Bear Markets

    Step into the psychological aspect of investing. Just as investor behavior can be irrational during bull markets, bear market cycles may also exemplify unique cognitive biases.
  5. Investing

    4 Behavioral Biases And How To Avoid Them

    Here are four common common behavioral biases for traders and how to minimize their effects on your portoflio.
  6. Financial Advisor

    8 Common Biases That Impact Investment Decisions

    Behavioral biases hit us all as investors and can vary depending upon our investor personality type.
  7. Financial Advisor

    3 Reasons You're Crazy for Not Investing in Stocks

    It's been more than five years since The Great Recession officially ended. It's time to invest in the stock market again.
RELATED FAQS
  1. How can I tell if I'm an emotional investor?

    Successful investors possess the important trait of emotional stability, which means that they base their investment decisions ... Read Answer >>
  2. What is the difference between accounting and economics?

    Discover the difference between accounting and economics by comparing and contrasting the financial discipline of accounting ... Read Answer >>
  3. What is the homo economicus?

    Homo economicus or "economic man" is the characterization of man in some economic theories as a rational person who pursues ... Read Answer >>
  4. What is the utility function and how is it calculated?

    Economists measure utility in revealed preferences by observing consumer choices and ordering consumption baskets from least ... Read Answer >>
  5. How does economics study human action and behavior?

    Find out why economics can be considered a deductive social science, like sociology, and how human action and behavior informs ... Read Answer >>
Hot Definitions
  1. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  2. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  3. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  4. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  5. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  6. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
Trading Center