Herbert A Simon got the Nobel Prize for economics in 1978 for his research on the decision-making process within economic organisations. A study of the history of behavioural finance cites his 1955 paper ‘A behavioural model of rational choice’ as the first thought that started it all.
The paper starts with the need for a revision of the economic model which assumes that the economic man is rational, has knowledge, is well organised with stable system of preferences, can plan alternative courses of action and reach highest attainable point on preference scale. But it also clearly states that the aim of the paper is not to discuss these doubts but to think about a revision — a direction towards a better economic model. The author mentions entities may possess a hierarchy of rational mechanisms and comparing computation with humans is very difficult, as both may get labelled as a moron in a different situation. This should shock some of the behavioural finance believers who have accepted clichés like “Human beings are nice and dumb” (by Terry Burnham of Harvard).
Herbert’s bounded rationality is a concept at the soul of behavioural economics. Daniel Kahneman (Nobel Prize winner, 2002) proposes bounded rationality as a model to overcome some of the limitations of the rational-agent models in economics. Putting simply bounded rationality suggests that there is never enough knowledge to take decisions and, hence, the limitations in decision making.
Unlike Daniel, Gerd Gigerenzer, a German psychologist, argues that heuristics should not lead us to conceive of human thinking as riddled with irrational cognitive biases, but rather to conceive rationality as an adaptive tool that is not identical to the rules of formal logic or the probability calculus.
Did behavioural finance gurus got it all wrong? Does this prove that fundamentalists are indeed correct in suggesting that behavioural finance is the great story of human errors?
It was not just the fundamentalists but even Gerd who mentioned about the behavioural finance over elaboration of human decision-making limitations and the human inability to cope with optimised thinking. Gerd talks about simple alternatives to a full rationalising analysis and how simple heuristics frequently lead to better decisions than the theoretically optimal procedure. After you read Gerd, heuristics suddenly start to sound better than what behavioural finance made it out to be — just an error.
Herbert’s initial thoughts on Artificial Intelligence were ignored for seven years. But the paper which I feel has not got its due attention in economics and psychology is the one he wrote in 1962 on the ‘Architecture of complexity’. In that paper, he said complexity frequently takes the form of hierarchy. Systems are hierarchic systems independent of specific content. He detailed hierarchical social systems, biological, symbolic, self-reproducing systems and even hierarchic structures in social interactions. Complexity had to evolve from simplicity. This was Herbert’s attempt to explain power law distributions (exponentiality in nature). Path of construction of a complex system is through the theory of hierarchy. If time is indeed a triad and hierarchical, we can easily comprehend Herbert’s architecture of complexity.
Can behavioural finance also suffer from bounded rationality? Claiming humans to be irrational when they were the ones who created such great things in the first place, the irrationality does not seem to add up somewhere. Can behavioural finance define and quantify long reversals in markets? Are these long reversals recurring?
How different are these long reversals from the subject of time cycles (order) written over the last few hundred years? Is there an order between passive index performances? Is this performance cyclical? If market success connected to addition and subtraction (Thaler, Lamont) what is the mathematics in long reversals and behavioural finance? How does behavioural finance change if time is the order Herbert was mentioning?
The author is CMT and co-founder of the global alternative research firm Orpheus Capitals
