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

    Rational choice theory is an economic principle that assumes ...
  2. Rational Expectations Theory

    The rational expectations theory posits that individuals make ...
  3. Adaptive Market Hypothesis

    The adaptive market hypothesis combines principles of the Efficient ...
  4. Herbert A. Simon

    An American economist and social scientist who won the Nobel ...
  5. Behavioral Finance

    Behavioral finance is a field of finance that proposes psychology-based ...
  6. Evolutionary Economics

    Evolutionary economics proposes that economic processes evolve ...
Related Articles
  1. Investing

    Behavioral Finance

    Learn the science behind irrational decision making and how you can avoid it.
  2. Managing Wealth

    The Science of Making Better Investment Decisions

    Neuroeconomics attempts to bridge neuroscience, cognitive psychology and economics in order to understand the mechanisms underlying economic decision making.
  3. Investing

    An Introduction To Behavioral Finance

    Curious about how emotions and biases affect the market? Find some useful insight here.
  4. Investing

    Don't Let Emotions Derail Investment Decisions

    Understanding behavioral finance can help you make better investing decisions.
  5. Small Business

    7 Ways Your Emotions Skew Your Business Decisions

    Important decisions such as making a key investment, increasing production or expanding into new lines are all clouded by human emotion. Can you stay cool under pressure?
  6. Financial Advisor

    A Quick Guide On Behavioral Funds

    Investopedia explores the working of behavioral funds, their benefits and risks, and an analysis of their past returns.
  7. Financial Advisor

    The One Thing Your Portfolio Must Always Have

    Portfolio diversification is essential in any situation, but especially so as the market finally returns to fundamentals.
  8. 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 is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
  4. 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 >>
  5. Are perfect competition models in economics useful?

    Take a look at some of the arguments made by the proponents and critics of the theory of perfect competition in contemporary ... Read Answer >>
  6. What is capital structure theory?

    Discover capital structure theory as it relates to financial management and the methods in which companies attempt to raise ... Read Answer >>
Trading Center