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.

RELATED TERMS
  1. Rational Choice Theory

    An economic principle that assumes that individuals always make ...
  2. Rationing

    Rationing is the practice of controlling the distribution of ...
  3. Rational Behavior

    A decision-making process that is based on making choices that ...
  4. Backward Induction

    In game theory, backward induction is the process of deducing ...
  5. Dollar Auction

    A dollar auction is a non-zero-sum sequential game where the ...
  6. Centipede Game

    The centipede game in game theory involves two players alternately ...
Related Articles
  1. Insights

    The Basics Of Game Theory

    Take an introductory look at game theory and the terms involved, and get familiar with backwards induction, a simple method for solving games.
  2. Investing

    Seven Controversial Investing Theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  3. Investing

    Modern Portfolio Theory Vs. Behavioral Finance

    Or: How financial markets would work in an ideal world vs. how they work in the real world.
  4. Trading

    Understanding Investor Behavior

    Discover how some human tendencies can play out in the market, posing the question: are we really rational?
  5. Investing

    Game Theory: Beyond the Basics

    Take your game theory knowledge to the next level by learning about the Nash Equilibrium.
  6. Personal Finance

    Consumer Spending on Travel Has Likely Peaked (PCLN, EXPE)

    While consumer spending on travel recovered quickly following the recession, it has been outpacing wage and GDP growth, and has thus likely maxed-out.
  7. Tech

    Are Big Budget Video Games Dead?

    More people seem to be gaming on tablets and smartphones over consoles, which means this could be the end of big budget console games.
  8. Investing

    Macy's Store Closings May Pace Other Retailers (M)

    Macy's announcement to close 100 stores is likely to be followed by other brick-and-mortar retailers—moves investors likely would applaud.
  9. Personal Finance

    7 Ways To Save On Last-Minute Travel

    Whether for an emergency or just a cheaper vacation, these tips can save you a ton of cash for last-minute travel.
  10. Investing

    PAGES: The Rational Optimist

    Jared Dillian, editor of "The Daily Dirtnap" shares why Matt Ridley's "The Rational Optimist" is his favorite financial read.
RELATED FAQS
  1. What is "marginalism" in microeconomics and why is it important?

    Find out what economists mean by marginal utility or cost and why marginalism is such an important concept in microeconomic ... Read Answer >>
  2. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
  3. What are the differences between weak, strong and semi-strong versions of the Efficient ...

    Discover how the efficient market theory is broken down into three versions, the hallmarks of each and the anomalies that ... Read Answer >>
  4. What does the Efficient Market Hypothesis have to say about fundamental analysis?

    Find out what the efficient markets hypothesis has to say about fundamental analysis and how recent finance research has ... Read Answer >>
  5. How can the problem of asymmetric information be overcome?

    Find out how market actors deal with the problem of asymmetric information, particularly when it leads to possible adverse ... Read Answer >>
Hot Definitions
  1. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  2. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  3. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  4. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  5. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  6. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
Trading Center