Do Irrational Investors Destabilize?

Abstract

In a financial market where all investors have valuable private information, full rationality requires that investors have an unlimited ability of figuring out the equilibrium model. Instead, I assume that due to a lack of knowledge or experience, some investors do not know the equilibrium model and use only their private information in forming their demand. By investigating the investment behavior of these “boundedly rational” investors and contrasting it with that of the rational ones, I find that in a market where the two kinds of investors coexist, it is the boundedly rational investors who contribute to price stability. The welfare implication is that, although each investor benefits from conditioning his asset demand on the information transmitted by the equilibrium price, it can happen that all investors lose by doing so because the equilibrium price becomes too volatile.

Keywords

irrational investor / destabilize / equilibrium / stability

RIGHTS & PERMISSIONS

2014 Higher Education Press and Brill