Behavioral finance FAQ / Glossary (Bounded rationality)

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Dates of related message(s)
in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

Bounded rationality

00/8i - 01/2i,9i - 02/2i,6i,7d
- 03/10i
+ see rational /
rationality, near rationality

Not easy to cut the bo(u)nds!

Let those who never goofed
throw the first ...irrational stone!

The economist Herbert Simon, one of the behavioral finance pioneers,
coined the term "bounded rationality".

It qualifies the fact that us, human beings, make rather often not well
grounded (if not fully fanciful) decisions, so that we behave:

In normal life, in an amateurish / suboptimal way
   towards our main life goals /
preferences.

   Here mental biases and limitations
   can
distort our analyses and choices.

This is not judging
* if those goals are good or bad (OK, a lack of rationality can also
   exist here),
* but if the person follows a rational strategy and a logical
   decision-making process
to reach them.

This is not the case, as an example, if it acts in a non "Bayesian"
way (see that word), by not fully adapting its judgment to
probability changes
that can be inferred from new events.


In finance / economics, areas where money is at  
    stake in a way not fully consistent with our financial interest (or
    more
precisely our expected utility).

Of course that definition is less valid if we have other goals
than pure financial interest.

If we use a more gradual logic than the binary distinction between
rationality
and irrationality (see those words), we can talk about
bounded rationality (this article) and (near) rationality (another article).

What are our rationality limitations?

Our engine does not deliver its full power.

Sand grains in the brain cogs?
Our mental gears might need some clean up.

Human decisions are rational (see that word) ...up to a certain point, as our
rationality is "bounded" by cognitive biases, urges, habits, emotions
or other internal or
external influences.

It is not so easy to juggle at all times with balls of different sizes and
weights, such
as our intentions, our capabilities, the group contagion
and our own impression about the situation, so as to take decisions that
bring optimum results.

Those limitations against rationality can be due for example to:

Messy information collecting and sorting

Limited by our senses (perception) and cognitive capabilities 
   
(reasoning, memory...)

Limited by our initial knowledge,

Our acquired education, however deep and diverse we might see
it, how much mental sweat it might has cost us, might be unfit
to
evaluate and process some types of new information.

Limited by the difficulty to sort overabundant information (see 
   
cognitive overload),

Messy decision making processes

Limited by the time available (or taken) to validate or infirm our

first perceptions and to make analyses and take decision,

Limited in our ability to do rational inferences and cost-benefit

analyses, or to avoid some irrelevant heuristics (see that word)

This bias becomes crucial when facing uncertainty, ambiguity, risk
and, of course, available alternatives,

Subject also to emotions which can lead to neglect some factors 

which are felt as disturbing (see cognitive dissonance).

Subject also to maladapted automatic reflexes and habits that

bypass thinking (sometimes luckily, to avoid inaction).

Neuroscience (see that word) is the field of research on how the
              
brain reaches decisions.Its findings shows that rational thinking is
               not always what dominates the process.

It studies what kinds of neurons are active in some situations and
what inner chemical secretions and electric connections fuel people
reactions.

In economics and finance specifically:

The rational expectation theory admits that human decisions are not
    fully
optimal, but it considers them as only marginally irrational. See

See (near) rationality.

Behavioral finance theories on the other hand finds rationality in some

situations,band full irrationality in others.

(near) Rationality


See rational, rationality,
(rational) ignorance,

bounded rationality

Borderline case

But is perfection really rational?

If we use a more gradual logic than the binary distinction between full
vanilla rationality and irrationality (see those words), we can talk not only about
bounded rationality
(see the related article), but also near rationality.

Sometimes, practical reasons, or just ...laziness, might make us deliberately
satisfied to behave in ways that seem not fully rational.

This is because to gather all missing data, analyze fully a situation and find

the optimal solution might need too much time, effort and cost (see
rational ignorance).

So, instead of aiming always at perfection, supposing it can exist, it
might be preferable sometimes:

To take a decision that is not totally rational, but that has a good 

chance to bring at least a satisfactory albeit suboptimal
outcome
.

It might be perfected later by trials and errors (see adaptive
process
),

...than to fall into apathy, passivity, indecision,

inaction or procrastination, which could be worse.

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This page last update: 09/08/15   

 

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