UNREASONABLE RATIONALITY

This paper explores how fractional demands (the optimal fraction of we alth invested in a security) change upon exogenous changes in security returns and wealth. In the first part of the paper, the analysis is c onducted in an Arrow-Debreu framework. Here we demonstrate the counter intuitive but completely rational result that fractional demands can r emain unchanged or in fact decrease upon an exogenous increase in retu rn. Furthermore, we show that this can occur without any offsetting we alth effect. In the second part of the paper, we apply these results t o ordinary securities (those composed of fixed portfolios of Arrow-Deb reu securities). Here eve derive a complete analytical solution and sh ow that portfolio managers should beware. Even correct information tha t the return from holding an underlying pure security will improve is not sufficient to conclude that one should increase (or decrease) one' s holdings of any particular stock.