Rational Expectations vs. Behavioral Biases: An Empirical Analysis of Trading Variability in International Capital Markets

Abstract

This paper presents a pioneering investigation into the impact of rational expectations and behavioral biases, such as animal spirits, on the variability of trading in international capital markets across five developed countries. By analyzing daily data, we aim to shed light on whether rationality or behavioral factors play a predominant role in shaping trading dynamics. Our empirical findings challenge the hypothesis of rationality, as we observe that rational expectations alone do not significantly account for the evolution of trading patterns. Instead, our results indicate that the economy is predominantly influenced by behavioral biases, with animal spirits emerging as a particularly noteworthy factor driving trading variability. This study contributes novel insights by providing empirical evidence of the prevalence of behavioral biases in shaping trading behavior across international capital markets. By highlighting the significance of animal spirits, we underscore the importance of considering psychological factors alongside rational expectations in understanding market dynamics. Our findings suggest that behavioral biases play a crucial role in driving trading variability, emphasizing the need for policymakers and market participants to account for these psychological factors in their decision-making processes. This research opens avenues for further exploration into the interplay between rationality and behavioral biases in financial markets.