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.
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.