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What is Bounded Rationality and what impact does it have on investments?

What is Bounded Rationality and what impact does it have on investments?

created Forex Club29 March 2024

Bounded rationality bounded rationality) is a term that is most commonly used in economics, but it can also be translated to other fields. In today's article, we will discuss how this socio-economic phenomenon may influence investment decision-making.

What is bounded rationality? Is this the opposite of homo oeconomicus?

For many years, economics was dominated by the view that people behaved rationally when making decisions. Economists believed that people chose the best available option among all available options. In this mental construct, each consumer carefully analyzes the price-quality ratio, product composition and quality of substitutes. This is certainly a beautiful theory, but it has one flaw: does not always describe actual decision-making. Homo oeconomicus does not exist because no one has enough time to thoroughly analyze every possible offer and make a final decision based on a reliable analysis.

Of course, there is also a theory opposite to homo oeconomicus, which states that people make decisions due to non-economic (i.e. emotional) factors. As a result, his choices are not optimal. Marketing strategies such as impulse purchases work on this principle.

However, there is a theory that combines both extreme points of view. He is limited rationality. In short, it means that people do not make decisions like homo oeconomicus and are not very emotional when making most choices.

He introduced the concept of limited rationality Herbert A. Simon. In his opinion, his concept reflects reality better than the assumption of full rationality. According to Simon, the following factors influence the decision-making process:

  • limited access to information,
  • cognitive limitations,
  • time available for analysis and decision-making.

In the case of the first issue, it is obvious that people usually do not have access to all publicly available information. This is sometimes due to laziness, and sometimes to save time (we will come back to this later). A separate issue is that sometimes people are not interested in obtaining additional information due to low economic utility. For example, buying new scissors has a low impact on the household budget. There are two shops next to each other that sell scissors. Homo oeconomicus would decide to check the price in both stores, the quality of cutting and the solidity of workmanship and buy the one with the best price-quality ratio. The consumer should do this because the cost of obtaining information is low. However, most often a person will buy scissors from the nearest store because they will accept that it is an imperfect solution but "good enough".

Cognitive limitations are a broad concept, but in this case we can focus on people's simplification of reality. This is normal because the amount of information we receive every day is enormous. The human brain deals with this by building simplified models. Some of them work well, but sometimes simplifications lead to incorrect conclusions. Decisions are also often made based on simplified reasoning. This is the result of our evolution, where in primitive times our brain had to learn to make decisions very quickly to avoid danger.

Another important variable in decision making is Time. Sometimes a person knows how to obtain the necessary information and avoids cognitive errors whenever possible. However, there are situations when there is no time to conduct a professional analysis. If a person is doing quick shopping because he or she will be late for work, he or she will not spend 15 minutes analyzing which fruit yogurt has the best price-quality ratio.

Research confirms the thesis that even companies use limited rationality. In one of them (“Bounded Rationality, Capital Budgeting Decisions and Small Business”) the authors reported that both Canadian and Mexican small businesses are simplifying their decision-making mechanisms. The so-called Bounded Rationality was used both to make decisions about capital investments and to develop the business itself (e.g. entering a new market). The study suggests that small entrepreneurs often use “gut feeling” rather than comprehensive analysis. This occurred especially in situations of high time pressure. Interestingly, some entrepreneurs made decisions despite being aware of the lack of sufficient information. however, they were not willing to bridge the knowledge gap before making a decision.

To sum up, in specific conditions people may decide to act suboptimal from the point of view of homo oeconomicus. Sometimes people decide to choose “good enough” solutions and not “the best in the world”.

Bounded Rationality in Investments

Bounded rationality is often seen in the investment field. Investors process information in a subjective way. This applies to both risk assessment and the final investment decision. The concept invented by Herbert A. Simon may suggest that many investors, traders and speculators may make investments based on, for example, heuteristics and one's own distorted worldview (so-called bias). Investors, like other people, build their own value system, which is their guide through life. On the stock market, your worldview and your own purchasing preferences should not influence your investment decision. However, people often make decisions based on their own view of the world. This is the case, for example cryptocurrency, when many investors believe that they are worthless “totems” whose value is based on herd behavior. However, such a view may deprive you of the opportunity to make money because of your own beliefs and not what the market says.

Another problem is that an investor may base investment decisions on so-called "anchoring", i.e. using irrelevant and outdated information.  Another problem may be the existence of a representativeness error, which may lead to the so-called "gambler's paradox" . The above-mentioned paradox is a cognitive error in which the investor believes that previous independent events influence the results of future events, e.g. if the market has been rising for three days, it will fall tomorrow. In our opinion Understanding bounded rationality can help investors identify and minimize psychological traps in investment decisions. You can counteract the negative aspects of this phenomenon by diversification, using investment checklists, etc developing your own risk management plan.

However, there are positive aspects of bounded rationality. After all, when you are looking for an investment opportunity on the stock market, you are unlikely to be able to thoroughly analyze several or several thousand companies. This would be impossible from a physical point of view. Moreover, even if you select a company for analysis, you most likely will not be able to analyze all available information. As a result, when making an investment decision, you will most likely use your own analysis that you have done “better done than perfect”. Thanks to this, being aware of your ignorance, you will make an investment decision faster, which may not be perfect, but good enough to buy, sell or stay aside.

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