Research Paper on Bounded Rationality in Financing

Paper Type:  Research paper
Pages:  8
Wordcount:  1948 Words
Date:  2022-05-04


Bounded rationality was proposed by Herbert Simon, and it means that people make decisions depending on the information that they have. This is an important topic to write about because organizations need to understand the determinant of a decision-making process. This topic is vital because many people make decisions based on satisfaction rather than optimization. This can affect an organization negatively because most of the decisions made will not be providing maximum productivity as required by the company. Bounded rationality has affected financial decisions made in organizations since people use information in their possession rather than making a decision that provides optimum. Therefore, this paper will look at explaining bounded rationality in finance, and how has impacted decisions made in organizations. Bounded rationality is important in finance and investments, and that will be discussed in this paper. This is because Simon explained the importance of bounded rationality by using a pair of scissors as a metaphor.

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Every person in a decision-making panel has the desire to provide a strategy that will provide an optimum result for the company, but there are several limitations to this rationality. This change brings about bounded rationality a shift from perfect rationality. Perfect rationality is the perfect idea that is based on logic, with the intentions of optimization. Bounded rationality, on the other hand, is influenced by available information. The main aspect that makes a decision to shift from perfect rationality to bounded rationality is the time available for a decision to be made. When there is limited time to make a decision, decision makers use the information they have to come up with a strategy. This is because they do not have time to carry out a research or consult on the issue. This information that they use might be wrong which might lead to a wrong decision. The information might also be inadequate. This shows that decision-makers will come up with a decision that has little value to the issue being countered.

The other aspect that shifts a decision from perfect rationality to bounded rationality is the limitation of human mind. This is because a human mind is limited to available resources and data. A person cannot make a decision using information that is not provided to them. For example, a finance manager cannot know the rate of inflation in the country if that information is not made available to him. This shows that he will make a decision based on the other aspects that he is aware of. This decision will not be the best since that is a factor (inflation rate) that has not been used in making the decision. The final aspect that makes rationality shift from perfect to bound is available information. As earlier discussed, decisions are made using available information. If the available information is right then the decision made will be liable for the issue being addressed. However, if the information is wrong then the decision made will be wrong. This shows that rationality of a decision is dependent on the information available. However, these three aspects are connected because the time available determines the information available (determining whether there will be a research or not), and this information is examined by human mind that can process information that is available only.

Stages of Rational Decision-Making

For bounded rationality to be understood, analysis of rational decision-making process has to be understood. Rational decision-making is the process of coming up with a decision with the highest optimization. The first step of rational decision-making process is the definition of the problem. This is important so that decision makers can understand the issue that they need to counter. This is also important so that they can formulate a viable research question. The second step of rational decision-making is determining the criteria that will be used in the decision-making process. This is vital because decision-makers need to understand how the process will be carried out. This is done by decision makers tabling their value and materials.

The third step in rational decision-making process is coming up with possible solutions that could be used in countering the problem. There are many ways to solve a problem, but decision-makers have to determine the one that will be initiated. Tabling all possible solutions will provide diversity when determining the solution to initiate. The next step is analyzing all the alternatives that have been provided by the decision-makers. This is done by listing the pros and cons of each alternative. This process leads to the final step which is determining the optimal solution.

This process shows that decision makers need a lot of time to carry out a research and analyze it to come up with an optimal solution. However, this might not be useful in case there is not enough time to carry out the research. For example, the stock market has become one of the highly rated investment platforms. There is little time available for investors to make perfectly rational decisions since rates change fast. Therefore, this is one of the sectors where bounded rationality is utilized. Investors use their cognition capabilities and the information they have to come up with the decision on where to invest. This is the reason Hebert Simon suggested that a combination of both cognition abilities and available information is enough to make a decision that can improve an investment.

How Bounded Rationality Works for Typical People

Decision-making process in bounded rationality is a simple model. This is because decision-makers tend to list a limited number of solutions. This is done by coming up with solutions that have been tested in the past and became a success. This shows that the solutions are viable since they have been experimented. They also decide on the alternative that is closest to the status quo. Decisions made do not need to be perfect, but satisfactory enough to counter the problem that is being processed by the administration.

When a problem is presented, decision-makers come up with a list of viable solutions, but they are not as many as in perfect rationality. These decisions have been used severally in the past. The next step is that decision-makers analyze the alternative starting with the one they think has the highest probability of being executed. Once they have come across the decision they find "good enough" they stop the analysis (even though there are other alternatives that had not been discussed). This is contrary to perfect rationality because all alternatives have to be given enough time and analyzed equally.

Mental Accounting and Its Effects

Mental accounting was introduced in 1999 by Richard Thaler in his paper "Mental Accounting Matters." this defines economic human behavior on how people spend their money depending on how they earned it. He explains that people have become irrational in their spending because they treat money differently. He explains that people place money in different "jars" to decide on the money they should not spend and the one they should waste. He introduces the term "fungibility" where he explains that people should treat all money the same regardless of how they earned it.

In this discipline of mental accounting, there is tendency of people separating their money into different accounts, the processes is based on the source of money and the economic purpose. According to the economist Albert Phung, every individual assign varied patterns of individuals group.

The process somehow has a typical model of irrational and detrimental results which influence their consumption and levels of their consumer behaviors? Although most of the people apply mental accounting in decision making, they do not comprehend the complex and illogical part of decision making process. An overriding example is that people have reserve of special "money jar" this is the fund set aside for acquisition of new home. The reserve is still held up while one is still doing some substantial credit or debit. The fact that when one is using money to pay debt it reduces the persons net worth, this is so because there is additional charge of interest on top of the debt. The simple concept of economic sense is that it is illogical to have little income while a reasonable percentage of income, an average of 20% goes to the accrued interest. In this context it is a fact that a lot of money is used to pay very expensive debt with increased interest overheads rather than saving in the jar.

The situation seems simple enough but then the people have to behave differently because there is a gap of perceived money value, how people regard the particular account. Imagine s situation where the money set aside to buy a new house at the expense of school fees. The funds in the valued account cannot be touched irrespective of whether touching the money in the account may have some positive effects to one's economic status.

The process of decision making operates within the confine of economic value and value attached to a particular set of accounts

In decision making one also experience some kind of accounts dilemma, different accounts have relative and close relationship depending on the value and mental accounting.

Consider an example where one go for lunch in a hotel and order for sandwich, then in the process of confirming whether you have enough money in the pocket for a lunch bill you discover that you lost some dollars. The real thing is that only six dollars are remaining. Unfortunate thing happens that in the process of taking the bite, the sandwich fall to the ground. The question is whether one will go back to the pocket and buy another sandwich. Some may consider the money lost as the unspent proportion and therefore may end up buying another. On the other hand one may choose to skip lunch because the proportion of money is already spent.

Situation Subjected to Mental Bias

People treat money according to the sources for instance people tend to spend more money if it is just " found" money such as tax return and bonus from work houses. This represents a clear description on how one may spend money depending on the mental bias, it is very hard to find someone overspending money that was expected from work ,logically speaking the spending of money should be done interchangeably, the value attached to the worked money should be the same as the one you have worked for. The consequence of spending money depending on the source may eventually have adverse effect. Possibly, it may lead to loss of one's wealth. On emphasis the misuse of money depending on the ultimate source may lead to a significant decrease in savings and hence the decision making.

The other crucial facet of decision making is invasion decision making process. The choice of investment is also regarded in the accounting bias where one makes the decision in the decision making process a person is involved to different perspective, first is the investment portfolio, second is the speculative portfolio.

The mental accounting bias also enters into investing. For example, some investors divide their investments between a safe investment portfolio and a speculative portfolio in order to prevent the negative returns that speculative investments may have from affecting the entire portfolio. The problem with such a practice is that despite all the work and money that the investor spends to separate the portfolio, his net wealth will be no different than if he had held one larger portfolio.

This assumption of these criteria is that money is the same irrespective of the use. Found money id no different from the money earned from work. Another extension of classification of money being fungible is discovering that saving money in an...

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Research Paper on Bounded Rationality in Financing. (2022, May 04). Retrieved from

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