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6.3 Bounded rationality

This illustration shows a stick person surrounded by a circle on the ground.
Figure 5 Bounded rationality can lead to poor decision-making.

Behavioural finance has emerged as the primary challenger to classical finance theories, such as Efficient Market Hypothesis, and has steadily grown in popularity over the last two decades.

As with most academic subjects, behavioural finance evolved over twenty to thirty years and, as an interdisciplinary field of study, it has drawn inspiration from a wide range of areas, such as psychology, sociology, finance and social psychology. However, if a starting point were to be considered, then Simon Herbert’s theory of bounded rationality is, arguably, the first tangible challenge to classical finance. Bounded rationality is a school of thought about decision making. It evolved in the 1950s to challenge the conventional thinking of the time that people act in a rational and common manner. Commonly accepted theories concentrated on the acceptance that preferences are defined by expected outcomes, that those outcomes are known and fixed and that decision makers maximize their net benefits by choosing the alternative that yields the highest level of benefits. So investment decision makers maximize expected value by always making the choices with the optimum outcomes.

Bounded rationality challenged this thinking by arguing that people, firstly, are never party to all of the available information relating to a decision and, secondly, make decisions based on their own values, skills, experience and habits.

So how might bounded rationality apply in the financial world?

Imagine a CEO of a large organisation, who has a mandate to grow the business through merger and acquisition (M&A) activity. The CEO’s previous personal and business experience will have shaped his aspirations and satisfaction levels. If the CEO had been involved in previously successful M&A activity, they may have a personal desire to do a bigger deal next time around to further their reputation and career targets. The CEO could also be influenced by other M&A activity in the business sector. This could cloud the CEO’s judgement as to whether the deal in question was right for the organisation or even right for the CEO.

Historically, there have been numerous mergers and acquisitions that that have been corporate disasters and which have destroyed shareholder value. One that particularly caught the headlines was the Time Warner AOL merger in 2001. This saw AOL buy Time Warner for $164 billion. However, in 2002 the company reported a loss of $99 billion – at the time, the largest loss ever reported in corporate history. In subsequent years, TimeWarner AOL had a turbulent management history. Eventually, in 2009, a de-merger occurred, with AOL becoming an independent company. The Chief Executive of Time Warner, Jeff Bewkes, subsequently commented that the merger ‘was the biggest mistake in corporate history’ (Daily Telegraph, 2010).

Unfortunately, very little research is normally applied to reviewing the behavioural causes of such poor decision making – although board members might subsequently consider whether there were personal motivations behind the CEO’s pursuit of this type of deal.