Bounded rationality: The realistic choice

Nov 5, 2018 @ 12:01 am

By The American College of Financial Services

Making a sandwich is easy. Making a perfect sandwich? Not so much. Standard economics assumes people make rational, utility-maximizing, optimal choices. But, how can we reconcile the belief that humans make rational choices when there are countless examples of when they do just the opposite?

One could argue that most choices do not come from perfect rationality, but rather from bounded rationality. In this post, you will learn about bounded rationality and how advisers and wealth managers can use the knowledge of its existence to their advantage.

Suboptimal sandwiches

The bounded rationality argument goes like this: People are rational, utility-maximizing, optimizers. However, they have limits. Sometimes they lack information. Sometimes they don't have the time to figure out the perfect answer. Sometimes, even if they took the time, cognitive limitations make it difficult to find the perfect answer. In other words, the bounded rationality argument says that people make the best choices given their imperfect and limited tools and resources.

Consider a simple example to illustrate the differences:

Suppose you want to make a peanut butter and jelly sandwich, so you go to the grocery store to buy peanut butter, jelly and bread. Assume there is, in the store, a perfect, utility-maximizing combination of peanut butter, jelly and bread, taking into account the cost and quality of each element and their combinations.

Will you make this perfect choice? Standard economics says, “Yes. You are a rational, utility-maximizing machine, and therefore you will make the best choice.” Except, this standard economic approach requires some assumptions. It assumes you have full external knowledge regarding every type of peanut butter, jelly and bread sold by the store.

The standard economic approach also assumes you have full internal knowledge. Crunchy versus smooth. Grape versus strawberry. White versus whole wheat. You know your exact preference rating for each food item. You know the order of this ranking, as well as the difference in experience between each and the financial value of the difference in experience. Finally, the standard economic approach assumes you will devote all the time and cognitive effort needed to select the optimal choice.

Bounded rationality as a solution

Bounded rationality gets rid of these unrealistic assumptions. Bounded rationality says you don't know everything about every product. And, if you spent all day just to think through all the financial, health and taste outcomes of your choice, you would be wasting an enormous amount of valuable time and effort. So, instead, bounded rationality says you make an optimal choice given your limited time, effort and information. Will you pick the perfect combination? Probably not. But, in this case, getting to perfection doesn't make sense because of the time and effort that would be required.

What does this have to do with managing wealth for individuals?

The same shortcuts that people use to choose peanut butter, they may also use to choose wealth managers or portfolio options. As an expert, you know a good deal about alpha, beta and important technical aspects of investment management. It's central to your task to build technically competent, optimizing portfolios.

But, is this enough to attract and retain clients? Bounded rationality suggests it may not be. It may not make sense for the client to become an expert on portfolio management, or even to develop enough expertise to understand the technical advantages of your approach. Instead, a client might use heuristics to determine quality by inquiring into the following:

  1. Who else uses you as a wealth manager?
  2. What designations of expertise do you have?
  3. Does your dress, your office and your communications convey success, seriousness and competence?

As a purely rational matter, we know that it's possible to have all of these things and still make technically inappropriate wealth management decisions. But, if we recognize that human decisions are not purely rational but are only boundedly rational, we can begin to appreciate how important these heuristic signs and signals are to the financial decision-making process.

Investing in education is the rational choice for advisers

In a recent study, it was found that consumers who valued designations, as well as those with higher incomes and investable assets, paid advisers more than those who did not. That being said, becoming a more educated and effective wealth manager is the best way to better serve your clientele and grow in your profession. The research is in, and, one might say, the choice is as simple as making a PB&J.

An expert team of investment researchers from The American College of Financial Services created the award-winning Wealth Management Certified Professional (WMCP) designation in order to serve a marketplace where individuals seek advisers with a true understanding of their unique needs and goals. Advisers with the WMCP designation have deep knowledge of personal wealth and investment management, including portfolio theory, behavioral finance, mastery of investment tools and advanced wealth management strategies.

This article was adapted from the behavioral finance curriculum in the Wealth Management Certified Professional (WMCP) education program developed by The American College of Financial Services.


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