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IS YOUR DECISION RATIONAL OR IRRATIONAL?

Consider a scenario of an individual who chooses to invest in the stock of organic product manufacturers because of the firm belief in the value of organic products. Even though the individual has the option of a conventional product with a higher return, still the individual will/may choose organic product irrespective of a lower return. The question which sprouts up, Is the decision rational or irrational?

Let's explore a little to find the answer.






What is rational behavior? It is the cornerstone of rational choice theory in economics, which assumes that individuals make decisions that provide the highest personal utility. Utility deals with the satisfaction which could be monetary (material benefit) or non-monetary (emotional). According to Von Neumann-Morgenstern's theory, an individual's decisions are well researched and in the best interest (utility maximization). For example, an employee has the option of either voluntarily taking retirement or completing the service. If an employee feels the benefits of retired life outweigh the utility from the receiving paychecks, then s/he will go for the former option. And if an employee falls into the category of risk-averse and has pre-thought goals (ex. Children's college education), then s/he will go for the latter option. Both scenarios would be considered rational choices for an employee. If this is the case, then who are irrational decision-makers.

There are scenarios where individuals do not always act rationally and are subject to biases in decision-making. As a result, the utility is not maximized. Thus, individuals end up taking risks that are unanticipated and unacknowledged. According to Kahneman and Twersky (1979), these biases come from prospect theory- “a descriptive framework for the way people make

choices in the face of risk and uncertainty." Cognitive psychologists interpret irrational behavior as the limitations in the human mind's ability to identify and process information. Individuals fall prey to a series of cognitive, emotional, and social forces.

“Investor’s chief problem and even his worst enemy- is likely to be himself.”

-Benjamin Graham

Thus, when it comes to money and investing, individuals are not always rational as others think. That is why there is a whole field of study that explains unusual behavior- Behavioral finance.