Behavioral finance: rationality and irrationality of investors

It is to sociology and the analysis of decision-making processes that we must turn to find a second analysis of human behavior in terms of evaluating their rationality. Herbert Alexander Simon develops the concept of bounded rationality, according to which an individual is dependent on a number of external factors in the rationality of his decision-making. This decision-making is conditioned, among other things, by access to information and its quality. This therefore presupposes that a priori a person does not have all the elements necessary to be able to make an optimal decision.

Moreover, other theories support this reasoning. Instead of irrationality in decision-making, Lindblom proposes the concept of incrementalism. This means a decision that is made through incremental development. There would thus be a certain rationality in the apparent irrationality of decision-making. In fact, it is more justified in a group situation, it is decided through negotiation and mutual agreement. So what seems illogical is only the fruit of a concentrated consensus. It also shows that the model of economic rationality cannot work because it does not meet the four criteria of rational decision making. Namely, the omniscience of the actor to make decisions, there must be no ambiguity about the goals, all participants must share the same values, the need for stable resources during the entire decision-making process.

Furthermore, with Crozier and Friedberg, the concept of a rational actor is constructed primarily in relation to the rationality of other actors. The rationality of the individual comes primarily from intersubjectivity.

On the other hand, another very relevant analysis comes from the model Trash can model or a trash can model. Developed by Cohen, March and Olsen, it introduces the concept of “organized anarchy”, that is, decisions do not depend on rational action, but rather on the choice that is most visible to the eye. Here, decisions are the result of chance rather than someone’s will. It is possible to develop three ideas to go deeper into this concept: the decision would not be the responsibility of the decision-maker (for example, we could have a person who simply approves the decision, such as a minister); it is difficult to isolate a specific act (decision), so it is perceived more like a decision-making process; it is not possible to identify a clear moment when a decision is made. It is therefore currently difficult to identify the influences that play a role in the decision. Moreover, most actors try to find “a priori” solutions. As soon as a problem or a question requiring a choice arises for them, they try to adapt their already prepared solutions to the problem.

These different theories show us how difficult it is to identify the regularity as well as the cause of an actor’s decision. Therefore, behavioral finance should not be taken as an exact science, but rather as a behavioral study allowing for the inference of a number of trends. Moreover, it has lost its usefulness in recent years and may lose some more. Man’s rationality has less and less need to understand in terms, while his actions are gradually replaced by machines. The use of algorithms, plugging in and improving computer models is increasingly important, and the self-driving nature of many of them is impressive. As is the case with HFT (high-trade frequency) models.

(1) They have been using the behavioral finance strategy for 18 years.

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