I often get asked about the meaning of “bounded rationality”, and how it relates to investing. This post will examine both the definition and relevance of this concept.
Bounded rationality is based on the premise that an individual’s rationality is limited by both his cognitive ability and environment: the purely rational economic man does not exist. Herbert Simon coined the term in 1955, and used the metaphor of a pair of scissors, where one blade is the “cognitive limitations” of actual humans, and the other the “structure of the environment”. According to Simon, studying one blade is not enough: it takes both for the scissors to cut. Minds with limited time, knowledge, and other resources can be successful by exploiting structures in their environments (Selten).
“Boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information. A great deal can be learned about rational decision making, by taking account of the fact that the environments to which it must adapt possess properties that permit further simplification of its choice mechanisms.”
In complex environments (such as the stock market), we can say that humans are not “unboundedly rational” but “boundedly rational”: they must “satisfice” to the best of their ability. Understanding limitations, and being aware of the biases and heuristics that can affect decision making, is extremely important to success. In truth, this lies somewhere between cognitive and ecological rationality, governed by simple and straightforward heuristics, which are often context dependent. There needs to be a balance, because using too few heuristics often leads to biases and sub-optimal decisions (Kahneman and Tversky), whilst the use of too many can often lead to confusion (Gilovich).
An illustrative example could be of some help here. Imagine we wanted to predict how an expert billiards player would hit a certain shot. We would measure the angles and distances, get the coefficients of elasticity of the balls and the bumpers, and we would solve a set of differential equations. But is that how the billiards player figures out what to do? I’m not so sure. We don’t know exactly what he would do, but surely optimization theory is not the most efficient way of figuring this out; the “fast and frugal heuristic” actually used by the billiards player would be much more useful.
Simon recommended that individuals think this way in order to make the most effective decisions in a given situation (that is, those with the highest expected value). He also recommended rethinking the norms as well as studying the actual behavior of minds and institutions. It is a multi-disciplinary concept, not unlike Charlie Munger’s idea of “multiple mental models”. Gigerenzer points out three distinct processes that these models specify:
- Simple Search Rules
- Simple Stopping Rules
- Simple Decision Rules
Using these rules as a foundation, individuals must develop an “adaptive toolbox” to deal with different problems in different circumstances – this is where the idea becomes relevant to investors. There are so many companies, with so many variables, that considering them all would be impossible, and considering every possible valuation metric would be quite confusing. Investors must learn to develop guiding principles, both for their selection procession and for their behavioral actions, when investing; they must try to act as rationally as is necessary, but no more. “It is the mark of an educated mind to rest satisfied with the degree of precision which the nature of the subject admits and not to seek exactness where only an approximation is possible.” ~ Aristotle.
Boundedly Rational Investing involves beginning with a simple and straightforward screening process, made up of 10 to 15 points, in both company analysis and individual behavior. It then involves shifting through masses of information and focusing on the few key elements which make a difference for the company in question (keep in mind, for instance, that all financial ratios are not relevant for all companies – adaptability is key). When analyzing a company, we are often dealing with the future, and therefore, with numerous assumptions. Starting with some checklist style tools – à la Charlie Munger – can help achieve a certain amount of clarity, which I believe is necessary.
To help you get started, I have pointed out heuristics used by some great investors; think of them as tools for the adaptive tool box. By checking them repeatedly, investors should be able to act in a sufficiently rational way when making their investments, which should greatly improve their chances of success. Although the purely rational man does not exist in complex environments, the sufficiently rational man does.
When considering this “simplistic” approach, be aware that it is mainly a learning framework to help build an appropriate process. It should be combined with significant personal study and analysis to become most affective: investing can be simple, but not easy.
“We selected investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business:
- Favorable long-term economic characteristics
- Competent management
- Purchase price attractive when measured against the yardstick of value to a private owner
- An industry with which we are familiar and whose long-term business characteristics we feel competent to judge”
“We look for good businesses with:
- strong barriers to entry
- limited capital requirements
- reliable customers
- low risk of technological obsolescence
- abundant growth possibilities
- and thus significant and growing free cash flow”
“The investments that have proven most successful for us include:
- Above-average to excellent companies as measured by high ROE in excess of 15% sustained over 10 years or more.
- Companies run by skillful managers as measured by good controls maintained on receivables, inventory and fixed assets.
- Prudent deployment of capital as measured by a company’s capital expenditures, judicious acquisitions, and timely buybacks of its depressed shares.
- A stock price which is far lower than what a knowledgeable and rational buyer would pay.”
“We seek simple, predictable, free-cash-flow-generative businesses that trade at a large discount to intrinsic value:
- Mid and large-cap companies
- Typically not controlled
- Minimal capital markets dependency
- Typically low financial leverage and most economic sensitivity
- Often hidden value asset base
- Catalyst for value creation which we can often effectuate
At the right price, we may waive one or more of the above criteria. Our selection process is designed to help avoid permanent loss of capital while generating attractive long-term returns.
Our concentrated portfolio has many advantages:
- Best idea fund (we invest in our 8 to 12 best ideas; we are always willing to replace an existing holding for a better opportunity)
- Provides transparency to our investors (few investments + detailed disclosure)
- Simplicity (we need only a handful of new ideas per year)
“Our portfolio discipline is to construct our portfolio from the bottom up. As value investors, we take long positions in good companies that we believe have clean and unlevered, or minimally levered, balance sheets and have misunderstood prospects. Of course, should the economy weaken they may earn less than they would in a strong or normal economy, but we believe that a lot of bad news is baked into their valuations and that these companies will survive the cycle. On the other hand, we are short companies that have significant problems of various sorts: some have bad business practices or have played accounting tricks; others trade at very high multiples of earnings expectations that are unlikely to be achieved; while others have flawed business models and are unlikely to be long-term survivors. We believe that over time, this is a sensible way to invest and will prove to be a lucrative portfolio construction methodology. Our investment strategy has always reflected time arbitrage in that we position ourselves to benefit from having a significantly longer-term horizon than other market participants.”
“There seems to be some perverse human characteristic that likes to make easy things difficult.” Warren Buffet
Note: This is a repost of an essay I wrote around a year ago, which various readers have asked me about.