Investors often group companies into categories, viewing them as either good or bad. If they see a company as especially good, most people hold onto their shares even when it announces bad news. Mullainathan found, however, that if there is bad news from a company that is just barely in the good category, investors overreact and sell their shares: in their minds, the company has fallen into the bad category. During the Internet boom, companies “tried to get into the Internet category,” redefining their businesses. Mullainathan cites networking company 3Com, which in an effort to boost the price of its stock, issued press releases that aimed to reposition the company. Mullainathan’s research shows that the more knowledge people had about investing, the less likely they were to group 3Com with Internet companies.Gabaix studies a different but similar set of problems that are related to the way people process information. People face complex problems every day, he says, and they take shortcuts that lead them to make irrational decisions. Gabaix points out that although it’s not unusual for people to have inadequate information about their options, traditional models don’t take this into account.
The tendency to make decisions on the basis of inadequate information and with a limited ability to process it helps explain the volatility of the stock market, Gabaix says. Although a given company looks much the same from one day to the next, its shares may fluctuate wildly as people make ill-informed decisions about buying and selling its stock.
Prelec offers another explanation for stock market volatility. Economists’ assumptions about rationality don’t capture the complexities of decision-making processes. Furthermore, he says that people’s valuations of goods are often not based on the goods’ underlying value.
Building models that explain irrational behavior is a leap forward in economics. But no matter how robust the new models, people will always make decisions that stump economists. After all, people invariably behave in ways that defy models, including ones that explain their irrationality.