In Praise of Investor Irrationality

47 Pages Posted: 6 Apr 2005

See all articles by Jeffrey J. Rachlinski

Jeffrey J. Rachlinski

Cornell Law School

Gregory P. Lablanc

University of Virginia - Department of Economics


How should a market filled with investors who chronically make bad investments, but is nevertheless efficient, be regulated? A growing body of evidence suggests that this is the state of most securities markets; investors rely on cognitive processes that produce systematically bad choices, and yet the market remains largely efficient. In fact, cognitive errors might be essential to their efficient operation. Even investors who make systematic errors also often possess real and unique information that can contribute to accurate pricing of securities. If such investors became mindful of their limited ability to distinguish between real information and erroneous information, they would decline to rely on their beliefs to invest and would thereby withhold private information from the market. Over-confidence on the part of these investors leads them to trade anyway. This over-confidence provides market liquidity, but more importantly, provides the market with the private information that individual investors possess (but should, rationally, withhold). Hence, reforms designed to save investors from the costs of their cognitive errors would reduce market liquidity and deprive the market of valuable information. In short, markets need irrationality.

Suggested Citation

Rachlinski, Jeffrey John and Lablanc, Gregory P., In Praise of Investor Irrationality. Available at SSRN:

Jeffrey John Rachlinski (Contact Author)

Cornell Law School ( email )

Myron Taylor Hall
Cornell University
Ithaca, NY 14853-4901
United States
607-255-5878 (Phone)
607-255-7193 (Fax)

Gregory P. Lablanc

University of Virginia - Department of Economics ( email )

P.O. Box 400182
Charlottesville, VA 22904-4182
United States

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