Rational vs Normal Investor

Liz Whitteberry |

There is an important distinction between the rational investor and the normal investor.


The rational investor makes all decisions from a purely analytic point of view using modern portfolio theory (MPT).  MPT was published by Harry Markowitz in the Journal of Finance in 1952 and was the first system that quantified a method to construct a portfolio based on a given risk level.  MPT constructs an "efficient frontier” to define the best possible portfolio mix for any risk tolerance.  


The selection of the assets for the portfolio uses mean-variance optimization (MVO) and relies on the efficient market hypothesis, put forth by Eugene Fama around that same time.  The efficient market hypothesis states that:

  1. financial markets are efficient,
  2. market participants are sophisticated, informed and act only on available information, and
  3. investors always make rational decisions.


As we can see, MPT describes how the financial markets work in the ideal world. 


The real world often works differently than the ideal world. 


In the real world, markets are not always efficient, stocks can trade at unjustified prices, and investors are normal people who make irrational decisions.


Thus, the normal investor operates better under behavioral portfolio theory (BPT).  BPT was put forth in 2000 by Shefrin and Statman.  BPT suggests that investors have multiple goals and create an investment portfolio to meet those goals over time. 


The selection of the assets for the portfolio is based on the goals, which should each be well defined. 


A behavioral portfolio resembles a pyramid with distinct layers for each goal.  The base layer is devised in a way that it is meant to prevent financial disaster, whereas, the upper layer is devised to attempt to maximize returns.  Bucket planning is an example of BPT. 


The distinction between the rational investor and the normal investor is the world in which their decisions are made.  The rational investor is someone who exists in the perfect world of the laboratory.  The normal investor is all of us people living real lives with the ups and downs and life changes that happen over time. 


In times like we’re going through now, MPT would suggest staying the course, whereas BPT would suggest staying the course IF the course were good to start with. 


Having a solid understanding of both theory and reality can help you make better investment decisions, so that you avoid unconscious mistakes that reduce your retirement security.