Bounded Rationality, Unbounded Confidence
March 17, 2015
by Baijnath Ramraika, CFA® and Prashant Trivedi, CFA®
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“The capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose solution is required.” – Models of Man, Herbert A. Simon
“Boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information.” – Oliver E. Williamson citing Herbert A. Simon
“There seems to be some perverse human characteristic that likes to make easy things difficult.” — Warren Buffett
Our rationality is limited by the information we have, the cognitive limitations of our minds and the finite amount of time we have to make a decision. Herbert A. Simon called that concept “bounded rationality.” As a consequence of these limitations, our confidence becomes unbounded. We will discuss the implications of this phenomenon and how investors can overcome it.
Simon argued that due to the complexity, dynamism and equivocality of present and future environments facing decision makers, we are not able to act in a fully rational way. This inability to act fully rationally results in a general state of satisficing, in which solutions that are not optimal are chosen if they meet minimum requirements.
Satisficing occurs because of the limited rationality of human mind, which is oftentimes not fully equipped to evaluate all possible consequences of decisions being made. As Simon stated, the capacity of the human mind is very small compared to the size of the problems we face. The result is that we process only a small fraction of information presented by real world problems and do so simplistically, by employing heuristics. When swamped by information, we select only a small portion of the total and end up with a dangerously different view of the world.
Figure 1 shows the impact of bounded rationality on complex decisions.
Figure 1
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