Modern economics makes an assumption for both social and economic behaviour, and that is that all individuals will choose the best course of action based on the stable preferences and limitations facing them.

This is known as "rational choice theory". Individuals will choose as rationally as possible based on the information made available to them. Though it is primarily an economic-social theory, rational choice theory is used in a number of fields, including criminology.

For the purpose of this lesson, however, we will look at the economic and psychological perspective of the theory.

It's your choice

Rational choice theory is based on the idea that group behaviours are the result of individual actions. Typically, people are motivated by money and the idea of making a profit, so the theory fits in well with economics.

The concept is that people tend to be rational in character, and will calculate costs and benefits of any action before deciding what to do. The theory therefore rejects the idea that social action may be anything other than rationally motivated, even when it appears irrational.

One would hope that this is how individuals act when they make their trading decisions: they choose trades based on rational decision-making and the information available to them.

But is this what really happens in the market?

Throwing the market into the mix

The stock market is made up of many individuals making a number of financial decisions. Rational choice comes in when traders try to anticipate outcomes of different courses of action, and calculate which choice is the best for them. Right?

Well, yes and no. As traders, we try to make the choice that seems like it will deliver the best possible outcome to us as individuals. However, even when a decision looks like a good one, there is no guarantee that the likely outcome will eventuate.

The stock market is characterized by a lot of players and a lot of conflicting individual activity, meaning that nothing is certain.

Check your emotion at the door

Rational choice won't always lead to successful trades, because there can be factors or information outside of our control that will lead to unpredictable outcomes.

However, rationality will always win out over emotionally-driven decisions, because it takes into account as much information as possible. Rational choice involves reinforcement. If a rational trading strategy is successful, the strength of this strategy will be reinforced by the reward of the successful trades.

Therefore, rational choices that lead to successful outcomes will be reinforced in our trading behaviour over time.

Carl Capolingua
Head of Education
Australian Stock Report
Follow Carl on Twitter @CarlCapolingua