Behavioral finance FAQ / Glossary (Bounded rationality)
This is a separate page of the B and R sections of the Glossary
Dates of related message(s)
in the Behavioral-Finance group (*):
Year/month, d: developed / discussed,
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
* 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
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
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
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.
See rational, rationality,
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
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
It might be perfected later by trials and errors (see adaptive
...than to fall into apathy, passivity, indecision,
inaction or procrastination, which could be worse.
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