Why Rational Models Fail in the Real World

Greg B Davies

Head of Behavioural Finance

Join Greg Davies as he explains why traditional financial models fail to capture real human behaviour under stress, and how behavioural finance brings psychology and emotion back into practical, resilient strategies.

Wealth Management

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Why Rational Models Fail in the Real World

13 mins 49 secs

Key learning objectives:

Understand the limitations of rational models in capturing real financial behaviour
Identify behavioural concepts such as loss aversion, hyperbolic discounting, and emotional liquidity
Describe how behavioural finance enriches rational frameworks with human realities
Apply behavioural insights to advice, product design, suitability, and risk management

Overview:

Rational models in finance offer elegant frameworks for pricing, risk, and decision-making, but their core assumption, that people behave predictably and rationally, often fails in practice. The 2008 crisis showed how models ignored messy human behaviour: fear, loss aversion, hyperbolic discounting, and intention–action gaps. Rational models are useful maps, but not the territory. Behavioural finance enriches them by reintroducing psychology, emotion, and individual differences, helping advisers design strategies clients can actually stick with. Effective finance requires both: rational benchmarks and behavioural insight to manage real-world decisions.

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Summary

Why do rational financial models fail in practice?
Traditional models assume investors are rational, consistent, and utility-maximising. They rely on simplifications such as risk being symmetric and time preferences being stable. In reality, people are loss-averse, discount the future inconsistently, and often act emotionally under stress.

These gaps explain why elegant models collapse when tested against crises or client behaviour. Rational models remain valuable as benchmarks, but they must be applied with caution and context.

What are the key behavioural limits of rational models?
People experience risk asymmetrically, feeling losses more intensely than gains. They also exhibit hyperbolic discounting, overvaluing immediate rewards at the expense of future benefits. Even when investors understand a long-term plan, fear or anxiety can override rational commitment during downturns.

This gap between knowing and doing highlights the importance of emotional liquidity: the psychological resilience needed to stick with strategies when markets are volatile. Both financial liquidity and emotional resilience are essential to withstand turbulence.

How does behavioural finance complement rational models?
Behavioural finance doesn’t discard rational frameworks but adds depth by acknowledging bias, context, and emotion. It explains why two clients with identical portfolios may behave differently based on traits like composure or impulsivity. It also equips advisers with tools such as financial personality profiling, default options, and tailored communications.

This integration ensures plans are not only theoretically optimal but also practical, survivable, and aligned with clients’ emotional capacities.

What are the practical implications for finance professionals?
Advisers should design portfolios that clients can realistically sustain, not just ones that look optimal on paper. Product designers must prioritise usability and framing, ensuring information is clear and supportive. Suitability assessments should consider psychological traits, not just financial capacity. Risk managers should monitor behavioural risk (stress, impulsivity, or hesitation) alongside market metrics. Regulation, such as the FCA’s Consumer Duty, reinforces this need by demanding the prevention of foreseeable harm, including behaviour-driven mistakes. The practical lesson: finance must account for human limits as well as market dynamics.

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Greg B Davies

Greg B Davies is a behavioural finance specialist and Head of Behavioural Finance at Oxford Risk, a fintech company focused on building behavioural technology to help people make better financial decisions. He started the first behavioural finance team at Barclays back in 2006 and has been working in this space for nearly two decades. He holds a PhD in Behavioural Decision Theory from Cambridge, and has spent his career turning academic insights into practical tools, such as measuring risk tolerance and designing nudges. He is also the creator of The Art of Behavioural Investing, a course designed to help everyday investors build better habits.

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