The prime state of investors rationality in their decision-making process given any time horizon may swing or deviate from absolute rationality from time to time. Results of many empirical tests of herding behaviour in financial markets only conclude if investors (individual/institutional) are either rational (say scale 0) or irrational (say scale 1). Now, is it possible to empirically test for the degree of rationality (e.g. evidence of herding behaviour) among investors within a 0-1 scale?
The use of benchmark investment portfolios or indexes (like S & P 500) tends to facilitate herding behaviors. You can test herding behavior of the investors with 0 = use of portfolio or 1 = does not use portfolio. Then you can test changes in the benchmark portfolio with the different asset’s performances.
There is a problem. Individual level of rationality influences collective performance of the market. However, market can follow random walk in two cases. If all agents are rational they understand such behaviour of the market and cannot derive the future trend. But if all agents are not rational and trade randomly, we will also observe random walk. So the same market behaviour can be for both extreme cases. More interesting case is when market is composed of agents with different types of rationality. There are noisy traders and trend chasers who can win in this market. There are some models with financial markets consisting of 2 or more types of agents with different rationality.
Herding behaviour need not mean that agents are not rational. Mostly, rationality is defined that all disposible information is (correctly) taken into account. Apart from how information is correctly used, this would mean that there would not be any rational decision, because collecting all the information (which could be got) would take such a long time and be so costly, that one would never make a profit. I remember when President Bush was in Japan and said that he sees the danger of a devaluation (instead of deflation), the Yen was down by around 10% at the Tokyo stock exchange (which is according to most economists the most efficient market) a half or one hour later. Is that rational? I fear, I have no satisfying answer to your question.
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