Rational Expectation

The last part of my Macro class talks about Rational Expectation: do people have rational or static expectation in making their economic decisions? The answer is neither.

Empirical study tends to put the ratio at 3 or 4 to 1: about 30% of population make systematic forecasting errors while the rest behave quite rationally; or the other way to put it is that the average Joe makes irrational decisions 30% of the time.

That sounds like a good rule of thumb to me, and I want to take one step further to explore the implications of this for our soundness of decision making. Let's assume(the typical way of starting something by an economist) that if we make irrational decision, we still get it right about 20% of the time ex post, probably it's just pure luck; and if we utilize all the information available and make a rational one, the outcome follows a random walk, i.e., it's a tossup and we get it right 50% of the time. If we just do the simple math to add them up:

0.3 * 0.2 + 0.7 * 0.5 = 0.41

That means for average Joe it's about only about 41% of chance that you will make a correct decision from hindsight. So next time when you realize that you've made a bad decision, don't beat up yourself: you are not alone.