What is the Paradox of Rationality

The paradox of rationality is the empirical observation, in game theory, that players who make irrational or naive choices often receive better payoffs than those making the rational choices predicted by backward induction.

BREAKING DOWN Paradox of Rationality

The paradox of rationality is consistently observed in experimental studies of game theory using such well-known games as prisoner’s dilemma, traveler’s dilemma and the centipede game — and underscores the contradiction between intuition and reasoning.

That people do not always behave rationally is a challenge to traditional economic and financial theories which assume perfect rationality, like the efficient market hypothesis that underpins the capital asset pricing model. Illogical financial behaviors by investors manifest themselves in large and persistent deviations of securities from their intrinsic values and phenomena like the asymmetric volatility phenomenon — even though market inefficiencies should theoretically be arbitraged away.

The Coexistence of Rationality and Irrationality in Financial Markets

Behavioral finance, which marries investment theory with psychology, has revolutionized our understanding of the role that cognitive and emotional biases play in producing stock market anomalies. But there are competing theories, such as evolutionary economics, which believe economic behavior is determined by both individuals and society as a whole, and socionomics, which suggest that social mood drives the economy and markets. To explain why rationality and irrationality coexist in complex systems like financial markets, some economists are turning to evolutionary biology and neuroscience to develop models of investor behavior such as the adaptive market hypothesis.