Bounded Rationality

In the real world it is unrealistic for individuals to behave according to the assumptions of traditional finance. You don’t see people walking around with a utility calculator inputting the amount of satisfaction they receive after consuming a good. Nor do you see people adjusting their risk aversion coefficient and build efficient frontiers.

Furthermore, traditional finance assumes individuals perform perfect analysis with completely perfect information. Behavioral finance, on the other hand, relaxes may of these assumptions and acknowledges that humans have both cognitive and emotional biases, as well as imperfect information. Traditional finance takes a normative view, i.e. how an individual should behave, while behavioral finance takes a descriptive view, i.e. why individuals behaved in a way that does not follow traditional finance.

The concept of bounded rationality relaxes the traditional finance assumption of completely perfect information. After all, it’s arguably impossible for an individual to acquire every piece of relevant information about an investment decision all at once, and then to analyze that information in a perfect, non-biased way.

Although bounded rationality relaxes the assumption of knowing everything there is to know, it still upholds the concept of acting rationally with the information at hand. In this way individuals are seen to “satisfice” themselves when making a decision. Satisficing involves meeting the minimum requirements for the goal at hand. Individuals already do this automatically.

Consider a situation in which you are shopping for a vintage car made in some specific year. In your search for this car you go to a dealership and they happen to have a vintage car made within the year you require, however it’s not running and needs some work. It may not be ideal that the car does not run, but you’re already at the dealership and it’s the correct year, so you buy it.

Bounded rationality comes in where you did not shop around and find out if there were other options at different dealerships, the only information you had was what that dealership offered. Satisficing comes in where you satisfied the year you required, even though the car did not run properly.

Cognitive Errors

This brings us to cognitive errors, the first type of individual biases we face in regards to investment decision making. Cognitive errors arise mainly from faulty reasoning due to incomplete information or improper analytical techniques. Due to the fact that cognitive errors are logical errors in nature, it is relatively easy to correct the errors through identification and improved analytical techniques.

There are two subsets of cognitive errors; 1) belief perseverance, and 2) information processing errors. Belief perseverance biases relate to the tendency to put too much weight on preconceived views, while information processing errors arise from improper analytical techniques.

The first subset, belief perseverance biases, their descriptions and consequences are as follows:

Bias

Description

Consequence

Conservatism

Evident when initial views are not updated with new information.

  • Hold investment positions too long.

  • Too slow in initiating a position.

Confirmation

Evident when only information that confirms the initial view is incorporated.

  • Low quality investment screening process.

  • Under-diversification.

Illusion of Control

Occurs when individuals think their participation in an investment influences the performance of that investment.

  • Overly complex investment screening process.

  • Under-diversification.

  • High amount of trading

Representativeness

Essentially an if-then deduction. An example may be a comment from the CEO being more important than deep analysis.

  • High amount of trading

  • New information (especially the source of that info) is either over-weighted or under-weighted.

Hindsight

The tendency to selectively remember information that confirmed the initial view. Making the initial view seem “obvious”.

  • Overestimate the extent to which they are correct.

  • Overly critical of others.

The second subset, information processing errors, their descriptions and consequences are as follows:

Bias

Description

Consequence

Framing

The effect by which an investment decision is influenced by how information is framed

  • Over weight short-term performance results.

  • Failure to account for risk to the extremes, i.e. too risk averse/risk seeking

  • Trading too frequently

Anchoring and Adjustment

When new information is related back to the initial view, i.e. the initial view is incorrectly kept as a reference point instead of rejecting it and starting again.

  • Too slow to incorporate new information.

  • Contaminating new forecasts with the initial view.

Mental Accounting

Money is treated differently depending on the source or perceived use of that money. Ignores the fungible status of money.

  • Failure to incorporate correlations between assets.

  • Inadequate diversification

Availability

Has to do with how easily the information comes to mind and resonates with the individual.

  • Inappropriate diversification.

  • Inadequate due diligence and investment screening.

The first and foremost way to mitigate these biases is to identify them and then be self-critical with regards to how the decision was made. In most cases it’s appropriate to keep detailed records of trades or investment decisions, stating why the decision was made and the reasons for it. From there, asking yourself critical questions such as: “have I considered all the relevant information available to me?” or, “Have I made this decision with an adequate amount of due diligence?”.

Unfortunately there is no simple way to correct these biases and is very subjective. Essentially, the individual will have to know their own vulnerability with regards to which of the biases they tend towards and be honest with themselves. Fortunately, though, cognitive biases are relatively easy to correct as long as you remain logical and honest with yourself.

Next: Prospect Theory

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