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Financial Formulas

Making Financial Decisions Is Rarely Entirely Rational

Studies in corporate finance make the assumption that people are rational decision makers. In fact, most economic models, financial and otherwise, assume that people act unemotionally and with a certain degree of competence. Here’s the reality, though: People are emotional, illogical, impulsive, and ignorant. That’s where behavioral finance comes into play. It defines what’s rational, identifies the causes of irrational financial behavior, and measures the financial impact of irrational behavior.

People rarely make any decisions, much less financial ones, entirely rationally. Why not? Four primary factors (other than corruption) lead people to forego rationality in favor of some other reasoning technique:

  • Lack of information

  • Lack of time to collect or process the information

  • Lack of ability to understand the information

  • Emotional impulse

At times when people have a limited ability to fully assess a situation, they often rely on reasoning methods that rely on experience-based judgments (known as heuristic methods) because people generally trust experience.

Maybe they listen to their “gut,” an emotional response that you can’t precisely identify the cause of, or perhaps they choose to employ some loosely applicable “rule of thumb.” Whatever alternative method they use, each one is subjective and, therefore, highly subject to irrationality.

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