The Apparent Madness of Crowds: Irrational Collective Behavior Emerging from Interactions among Rational Agents

Abstract

Standard economic theory assumes that agents in markets behave rationally. However, the observation of extremely large fluctuations in the price of financial assets that are not correlated to changes in their fundamental value, as well as the extreme instance of financial bubbles and crashes, imply that markets (at least occasionally) do display irrational behavior. In this paper, we briefly outline our recent work demonstrating that a market with interacting agents having bounded rationality can display price fluctuations that are {\em quantitatively} similar to those seen in real markets.