Most people familiar with behavioral economics will probably have heard of Daniel Kahneman and Amos Tversky. They are pillars in the field of psychology and were even the subjects of Michael Lewis’ latest best-selling book.i Somewhat lesser known, but by no means less influential, is Herbert Simon. Last week marked what would have been the late Herbert A. Simon’s 101st birthday. Simon was a pioneer in the study of decision-making among individuals and organizations, which earned him the Nobel Prize in 1978. His research is applicable to several domains including political science, psychology, and economics.
Simplistically, the concept of bounded rationality posits that there are limitations to human cognition with respect to information availability and the amount of time required to make an optimal decision. There is a growing body of research highlighting the inherent biases and emotionally-charged reasoning that derail individuals when making choices. Many of the research and studies that led to the realization of these behavioral biases can be traced back to Simon’s work. Yet, despite over half a century’s worth of research, there are still economic theories that rest on rational human behavior. It is not difficult to see how assuming optimal rationality among all decision makers in a complex web of participants with differing interests can lead to spurious results. In a world of constantly evolving information, it is important to recognize the distinction among that which is known, and that which is unknowable, and to make the most appropriate decision in a limited amount of time.
Even with all available information at hand, the ability to process it quickly and accurately is not always possible. Add in the biases and utility-maximizing thought can start to break down—especially when juggling competing interests. Simon used another term “satisficing” – to explain how within the realm of bounded rationality we can still make a satisfactory decision that is sufficient to meet a stated goal. This is not to be thought of as a form of settling on an inferior solution. It is actually making the best choice given the informational environment, as opposed to believing we can make a better one based on things we cannot know. I’ll let Simon explain:
“The central problem of this paper has been to construct a simple mechanism of choice that would suffice for the behavior of an organism confronted with multiple goals. Since the organism, like those of the real world, has neither the senses nor the wits to discover an “optimal” path – even assuming the concept of optimal to be clearly defined – we are concerned only with finding a choice mechanism that will lead it to pursue a “satisficing” path, a path that will permit satisfaction at some specified level of all its needs.”ii
Simon helped spawn the development of behavioral economics, which we believe is a superior mode of thinking compared to traditional efficient market models. At 361 Capital, it is a philosophy that guides our investment processes and decision-making. We do not pretend to know more than everybody else and do not attempt to make predictions. What we do is make systematic decisions based on rigorous testing and information we have. The anomalies our equity strategies attempt to exploit are based on actual observable behavior—not predictions of what ought to happen. Bounded rationality keeps us humble and weary of those that proclaim to always be sure of what will happen. Models based on the way people should act or that assume we will always make a utility-maximizing choice are tenuous at best.
To conclude, I’ll leave you with the concluding statements from Simon’s 1956 paper:iii
“The analysis set forth here casts serious doubt on the usefulness of current economic and statistical theories of rational behavior as bases for explaining the characteristics of human and other organismic rationality. Its suggests an alternative approach to the description of rational behavior that is more closely related to psychological theories of perception and cognition, and that is in closer agreement with the facts of behavior as observed in laboratory and field.”
Well said, Herbert.
Read our related white paper, Bounded Rationality: Tapping Investor Behavior to Source Alpha