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Paradox of Rationality
The paradox of rationality refers to a game theory’s empirical observation where players who make naive or irrational choices always tend to receive better payoffs compared to those that make rational choices through backward induction.
A Little More on What is the Paradox of Rationality
People who see themselves as persons of logic strive to make rational decisions, that lead to the desired outcomes. A paradox is about believing that you always tend to make rational decisions and that others do the same thing. However, according to rational analysts, there is no truth in this kind of reasoning. That almost every choice you and I make is subconscious.
The paradox of rationality can be perceived in games theory’s experimental studies when you use well-known games such as traveler’s dilemma or prisoner’s dilemma as well as the centipede game and underlines the contradiction between reasoning and intuition.
The paradox of rationality asserts that since people don’t always behave rationally, it becomes a challenge to financial theories and traditional economics that assumes perfect rationality, such as the efficient market hypothesis that reinforces the capital asset-pricing model.
Investors’ illogical financial behaviors come up in securities’ persistent and large deviations from their intrinsic values and phenomena such as asymmetric volatility phenomenon. It happens even if market inefficiencies are theoretically arbitraged away.
Rationality Coexistence and Financial Market Irrationality
Behavioral finance, which connects to investment theory with psychology, revolutionizes our understanding of what emotional and cognitive biases play in the production of anomalies in the stock market.
However, we have competing theories like evolutionary economics, which believe that society and individuals are the ones that determine economic behavior. Also, socioeconomics suggests that markets and economies are, to some extent, driven by social mood.
Generally, when the system is complex, it becomes difficult to explain the coexistence between rationality and irrationality. In recent times, economists have turned to neuroscience and evolutionary biology to develop investor behavior models like the adaptive market hypothesis.