People are rational even when they are behaving irrationally

People are rational even when they are behaving irrationally

When we are building up some economics models, we usually assume that people are all rational, even the markets show sometimes the opposite. Are they really irrational? The answer is no, people are all making their best decisions with their different constraints of information collecting capacity. 

Usually, we believe that anyone should make his/her decision after receiving all possible information. This is incorrect. Reacting faster means the variation of expected future returns becomes greater, as well as less information. The making correct prediction can receive greater benefits. Spending more time on collecting information will narrow the variation of future outcome. However, when the time is in progress, people are keeping receiving more new information from the market, such as prices; therefore, people’s expectations are also changing. People will make correct predictions more likely, but never with 100% certainty. In addition, time itself creates opportunity cost, spending more time means an increase of cost. 

Moreover, people’s expectations are interacting. Sometimes people believe the others may have more information. Therefore, the effects of information are multiplied by such belief, leading to some overreacting of the market.

In conclusion, people all make decisions rationally. People need to decide whether they react faster with lower opportunity cost but higher risk or react less fast with greater opportunity cost but lower risk.