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Rational Thought vs Bounded Rationality

The Rational Agent Ideal

Traditional finance assumes perfect rationality:

  • Unlimited cognitive capacity
  • Perfect information processing
  • Consistent preferences
  • Optimal decisions always
  • No emotions influencing choices

Reality: Humans are "boundedly rational" (Herbert Simon, 1955 Nobel Prize).

Bounded Rationality

Definition: Decision-making constrained by:

  • Limited cognitive capacity
  • Incomplete information
  • Time constraints
  • Computational limits

Result: "Satisficing" not optimizing—good enough decisions, not perfect ones.

Key Differences

Perfect RationalityBounded Rationality
Unlimited processing powerLimited attention, memory
All information availableInformation costly to acquire
Optimize perfectlySatisfice (good enough)
Mathematical modelsHeuristics, rules of thumb
No biasesSystematic biases

Heuristics: The Solution to Bounds

Faced with complexity, humans use mental shortcuts (heuristics):

Availability: Judge probability by ease of recall
Representativeness: Judge by similarity to prototypes
Anchoring: Over-rely on first information

Benefit: Fast, efficient decisions with limited resources
Cost: Systematic errors and biases

Investment Implications

Bounded investors:

  • Can't analyze all 5,000+ stocks → Focus on familiar names (home bias)
  • Can't calculate optimal portfolio → Use simple rules ("60/40 stocks/bonds")
  • Limited time → Follow analyst recommendations instead of own research
  • Information overload → Stick with past choices (status quo bias)

Not irrational, but practically rational given constraints!

Satisficing in Finance

Optimization (ideal): Find absolute best investment among all global assets

Satisficing (reality):

  • Screen for P/E < 15, dividend yield > 3%
  • Pick first 10 that meet criteria
  • Diversify equally
  • Good enough! vs spending months finding "optimal" weights

Herbert Simon's insight: In complex environments, satisficing often outperforms attempted optimization (which fails due to cognitive limits).

Implications

For individuals: Accept cognitive limits, use systematic rules

For markets: Bounded rationality creates:

  • Predictable patterns (momentum,value)
  • Exploitable mispricings
  • Role for active management

For regulators: Simplify disclosures, use defaults

Key Takeaways

  • Perfect rationality: Unrealistic ideal of unlimited cognitive capacity
  • Bounded rationality: Real humans satisfice given limits
  • Heuristics: Mental shortcuts that are fast but biased
  • Investment impact: Home bias, simple rules, satisficing strategies
  • Not irrational: Practically rational given constraints

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