When you were asked: "Are you a rational investor?" You would probably answer: "Well, yes! I guess. At least I THINK I am rational when making investment decisions." Not according to Bayes' Theorem. The definition for rationality according to Bayes' rule is:  Logical thinking should involve probabilities, hypothesis and statistics to one's belief. In other words, one should use statistical evidence to quantify his or her belief.

In the classical financial market efficiency theory, it is assumed that investors are rational with perfect information. Rational investors make decisions or judgement using reasoned thinking, based on facts, applying rules. However, in the real world, those described above do exist, but only for the minority. The majority of the market participants are irrational, at least according to the Bayes' rule. If you look around people around you, you would notice that when faced with investment decisions, they prefer to listen to rumours and tips, rather than spending time doing the research themselves.

This 'misbehave' of humankind is actually discovered by the Nobel Prize winner, Professor Kahneman, who started the Behavioural Finance theory with Tversky in the late 70's.  When conducting statistical research with a group of professional statisticians, they discovered that these experienced statisticians do not apply rules, but their own intuitions when it comes to simple problems given to them.

Likewise, when we need to make investment decisions, we may encounter some mental biases that prevent us from thinking rationally. In the following section, we shall discuss what are those and how we can overcome them.

Overconfidence

Herd Mentality

Confirmation Bias