Bounded Rationality in Decision Making
By Ananya Taneja
Which career path should we pursue? When is the right time to sell our securities? Which flight should we take to reach our destination?
Every day, we have to choose between the different options available to us, and the choices that we make ultimately guide the path of our life. In order to improve the way we make decisions, there is a need to understand the different ways our mind’s cognitive process works – analytical or intuitive, conscious or unconscious, quick or time-consuming.
Let us think of a situation, say, buying the perfect paper for a project. Several vectors have to be considered before going ahead with the purchase-thickness of the paper, colours available, textures, durability, and so on. We might look around for the paper that suits us the best in perhaps a 5km radius and select the same one every time we have to make a new project, even if there are better quality papers out there.
When we think of all the decisions that we have to make daily – big or small, trying to make the optimal decision is often not possible.
Our cognitive thinking abilities are ‘bounded’ because of various limitations such as the complexity of options, lack of information, and time constraints. Spending a huge amount of time and effort to make a minuscule decision would make us irrational. Do we need this irrationality to make a rational decision? No. We tend to ‘satisfice’ ourselves with what we think is good enough and don’t put any more effort in making that decision.
This concept of bounded rationality was introduced by Herbert A. Simon, challenging the neoclassical economic model of decision making which assumes human beings to be rational agents. Simon recognised the cognitive limitations that decision-makers face when it comes to acquiring and processing information, thus relying on heuristics or rules of thumb to make quick decisions. The notion of ‘cognitive bias’ used by Amos Tversky and Daniel Kahneman describes the systematic errors in judgements as a result of these heuristics. These in turn deviate our decisions from what is considered to be desirable or logical.
Some common cognitive biases include the Mere Exposure Effect, which is the tendency to prefer things merely because of familiarity. Then there’s the Bandwagon Bias, the tendency to form a particular opinion because others have done so, just like choosing a career for yourself because XYZ was successful in it.
Another bias that we can practically see around is the halo effect which allows a person’s positive traits to extend from one area of their personality to another in others’ perception of them. For example, if we meet someone at an event and have a pleasant conversation with them, we would end up having a positive viewpoint about their entire character based on the tiny chit-chat. That’s why they say that the first impression is the last impression, even though there is a high chance that the perception formed after the first meeting is flawed. In his book Thinking, Fast and Slow, Daniel Kahneman describes this as ‘exaggerated emotional coherence’. Our mind tends to oversimplify situations when we are not given sufficient details. The book further talks about self-control depletion-how after exercising self-control to perform a task, our capacity to do the next one reduces.
This brings us to the concept of bounded self-control. What stops us from making the right decision for ourselves? Workers want to save money, we want to adopt a healthy lifestyle, some smokers want to quit, and we definitely do not like to procrastinate but still end up doing it. People might have good intentions, but the instant gratification derived from doing something in the present undermines the need to think about the future. This is why 90% of investors lose money in stock markets in the pursuit of making quick money. The propensity of an individual to overreact when exposed to new information has often led to overvaluation or undervaluation of investments, as seen in the study conducted by Werner De Bondt and Richard Thaler (1985). This propensity often gives rise to speculative bubbles, which is seen in many asset classes including the crypto market with drastic fluctuations in the value of bitcoin.
The main question that arises when we talk about bounded rationality and bounded self-control is – how do we make the right decision? Well, there is no hard and fast rule for this. In order to have the correct approach, there is a need to identify and outsmart our own biases.
We do not like to be wrong and hence justify our bad decisions to protect our self-perception, however, it will lead us nowhere. The underlying bias behind rationalising a bad decision, the confirmation bias, talks about the tendency to look for evidence that supports our pre-existing beliefs and to ignore information that counters it. Reflecting on the past rather than rationalising our poor decisions is indispensable.
To overcome biases and blindspots while making a decision, we have to broaden our perspective, surround ourselves with multiple viewpoints, assess the uncertainties, and consider facts and data before relying on intuition. We live in a very polarised society. There is a need to look at both sides before forming an opinion or making any decision and if needed, to find the grey in the black and white.
Tversky, A., & Kahneman, D. (1974). Judgement under Uncertainty: Heuristics and Biases. Science, 185(4157), 1124–1131. https://doi.org/10.1126/science.185.4157.1124
Kahneman, D. (2013a). Thinking, Fast and Slow (1st ed.). Farrar, Straus and Giroux.
de BONDT, W. F. M., & THALER, R. (1985). Does the Stock Market Overreact? The Journal of Finance, 40(3), 793–805. https://doi.org/10.1111/j.1540-6261.1985.tb05004.x
EconomicsOnline. (2021, November 9). Bounded rationality in decision making. https://www.economicsonline.co.uk/behavioural_economics/bounded_rationality_and_self_control.html/
Bounded Rationality (Stanford Encyclopedia of Philosophy). (2018, November 30). Https://Plato.Stanford.Edu/Index.Html. https://plato.stanford.edu/entries/bounded-rationality/