This article formalizes investor rationality and irrationality, exuberance
and apprehension, to consider the implications of belief formation for the
fragility of an economy's financial structure. The model presented generate
s a financial structure with portfolio linkages that make it susceptible to
contagious financial crises, despite the absence of coordination failures.
Investors forecast the likelihood of loss from contagion and may shift pre
emptively to safer portfolios, breaking portfolio linkages in the process.
The entire financial structure collapses when the last group of investors r
eallocates their portfolios. If some investors are irrationally exuberant,
the financial structure remains intact longer. In fact, financial collapse
occurs sooner when almost all investors are rationally exuberant than when
they are irrationally exuberant. Additionally, a financial crisis initiated
by real shocks is indistinguishable from one caused solely by the presence
of rationally apprehensive investors in a fundamentally sound economy. Pol
icies that make portfolio linkages more resilient can improve welfare.