Bounded Rationality: Recognizing the Limits of Decision-Making in Investing
Why perfect decisions are a fool's game (and how to win anyway)
Maryam Mirzakhani was the first woman to win the Fields Medal, mathematics' highest honour.
She developed an unconventional approach to solving extremely complex geometric problems that beautifully illustrates the concept of bounded rationality in creative work. So, what did she do? When tackling problems that even brilliant mathematicians found overwhelming, Mirzakhani didn't attempt to process all possibilities simultaneously—she knew this exceeded human cognitive capacity.
Instead, she developed what colleagues called her "doodling technique." She would draw elaborate diagrams, repeatedly sketching the same problem from different angles and perspectives. Rather than trying to solve everything at once, she broke impossibly complex geometries into manageable visual chunks her mind could process. Her notebooks contained hundreds of pages of these drawings for a single problem.
This approach acknowledged the bounded rationality of even a mathematical genius. By externalizing part of her thinking process onto paper and approaching problems from multiple simplified angles rather than attempting comprehensive analysis, Mirzakhani made breakthroughs in hyperbolic geometry that had stumped mathematicians for decades. Her method demonstrates how working within cognitive limitations rather than fighting against them can lead to extraordinary innovation—a principle that we will see, is directly applicable to investment decision-making.
Or take cognitive psychologist Gary Klein. He spent years studying how experienced firefighters make decisions under extreme pressure.
In one famous incident he documented, a lieutenant led his crew into a seemingly routine kitchen fire. Moments after entering, the lieutenant had an inexplicable feeling of danger and ordered everyone out. Seconds later, the floor collapsed—the fire had actually been in the basement.
When Klein interviewed the lieutenant, he initially claimed he had ESP. But later analysis revealed something a bit more interesting: the lieutenant's subconscious had processed subtle cues—unusually quiet flames, excessive heat, lack of expected kitchen fire patterns—that his conscious mind couldn't articulate in real-time. Rather than conducting a formal analysis of all variables (impossible under time pressure), his experienced brain had created a rapid pattern-recognition shortcut based on previous fires.
Klein called this "recognition-primed decision making"—a perfect example of bounded rationality in action. The firefighter couldn't possibly analyze all environmental variables explicitly, so his brain adapted by creating efficient heuristics that worked within his cognitive limits.
So, what does bounded rationality actually means?
Imagine being a portfolio manager in the middle of earnings season. Dozens of reports and data points flood your screen. You want to be perfectly rational in parsing it all – but you’re only human. You know, you zoom in on a few key metrics, skim the rest, and make a “good enough” decision under time pressure. Well, congratulations – you’ve just applied bounded rationality in investment decision-making.
This concept, pioneered by Nobel laureate Herbert Simon, acknowledges that our decision-making is constrained by cognitive and informational limits. So, in the real world this can be a source of competitive advantage.
In this article, I’ll explore what bounded rationality means for investors, how it contributes to market inefficiencies and mispricings, and how experienced practitioners can leverage this insight.
Sometimes simpler is better.
Let’s dive in.
Understanding Bounded Rationality – Every Investor’s Three Limitations
So, what did Herbert A. Simon really meant when he tried to describe how real people make decisions within the limits of their knowledge and brainpower?
You see, in contrast to the ideal of the perfectly rational “economic man” who optimizes every choice with unlimited information, Simon argued that individuals satisfice – they seek an outcome that is “good enough,” given their constraints. In Simon’s words, human rationality is bounded by “the difficulty of the problem, cognitive capability, and time available”. Rather than exhaustively analyzing every option, we narrow our choices and settle for a satisfactory solution when an optimal one is out of reach.
Satisficing: Because humans cannot possibly obtain or process all the information needed to make fully rational decisions, they use what information they do have to achieve a result that is “good enough,” a process Simon famously called satisficing.
You may already know where I’m going with all this. While making an investing decision, is impossible to have perfect information. We have to settle with good enough. But, how good is good enough?
Every investor is limited by:
Cognitive capacity (we can only analyze so much data),
Information availability (we never have perfect or complete data about the future) and,
Time constraints (markets move quickly, decisions often must be made fast).
Under these bounds, even rational people will forgo perfect optimization in favour of workable solutions.
Bounded rationality doesn’t imply people are irrational – rather, they are rational within limits. We do our best with the mental bandwidth and information we have in the time we have available.
As Simon put it, the human mind’s capacity for solving complex problems is tiny relative to the vast complexity of the real world.
You may already be thinking about AI. And yes, it definitely will help with time and cognitive capacity but it still will be limited by information availability.
For human investors bounded rationality is a daily reality. No one can analyze every stock, every economic indicator, or every geopolitical development impacting markets. Instead, investors use shortcuts, experience, and selective focus to make decisions:
Heuristics and Rules of Thumb: Investors often rely on heuristics (mental shortcuts) to cope with complexity. For example, a stock investor might use a P/E ratio rule (buy if P/E < 15) or prefer companies they’re familiar with. These shortcuts simplify choices but of course, can omit nuance. Amos Tversky and Daniel Kahneman famously showed that under uncertainty, people use a limited set of heuristics to reduce complex tasks to simpler judgments – useful generally, but sometimes leading to systematic errors.
Selective Attention: Out of an ocean of information, we selectively process only a subset. Perhaps you zero-in on a company’s cash flow and debt levels, ignoring other details. This focused approach is often necessary – but it means some information is always left out. Bounded rationality implies we only digest a slice of reality, which can yield a distorted view of the investment you are looking at.
Emotions and Biases: Cognitive limits feed into behavioral biases. When overwhelmed, we as investors might fall back on instinct or crowd behavior. Overconfidence is a common bias rooted in bounded rationality – with limited knowledge, investors over-estimate their understanding of a situation. Likewise, herding (following what others are doing) is an easier decision shortcut when independent analysis is hard.
Time Constraints: An investor might have to decide today whether to sell a falling stock or hold on, without the luxury of perfect information. Under time pressure, even thorough analysts must simplify – perhaps basing the decision on a few key data points or gut feeling. This is bounded rationality in action: making a timely decision that is acceptable, if not perfectly thought-out.
The best investors recognize their cognitive limits and design their strategies accordingly, as we’ll see in examples later.
Do You Think This Only Happens to Investors? What About CEOs?
Corporate managers and CEOs deal with it constantly. Consider a CEO weighing a major acquisition or a CFO deciding on next year’s capital expenditures. Nobody has perfect information, infinite time and massive cognitive capacity.
Instead, executives satisfice – they make good enough decisions given incomplete data, finite analysis time, and internal pressures.
Understanding how bounded rationality affect management and corporate decision makers could definitely help the investor to make better decisions.
Examples of this phenomenon in corporations are:
Limited Information: As I said before, managers rarely have all the facts. They must make strategic bets with partial information – e.g. launching a new product without knowing exactly how the market will react, or expanding to a new region with imperfect knowledge. They gather as much data as possible, then choose an option that meets key criteria (profitability, strategic fit) even if it’s not proven optimal.
Complex Choices Simplified: Corporate decisions can be mind-bogglingly complex (think of planning a multinational’s supply chain or restructuring an organization). Good CEOs often simplify the problem by breaking it into parts or focusing on a few critical variables. For example, a CEO might decide that entering a new market hinges primarily on two factors – potential market size and regulatory hurdles – and make the go/no-go decision mostly on those, essentially bounding the decision by what their team can thoroughly analyze which are not always critical factors for success. So this is a good line of questioning when you are talking to management.
Organizational Pressures: Simon pointed out that decision-makers are also bounded by social and organizational factors. Politics. A manager can’t act with pure individualistic rationality; they must consider internal politics, stakeholder interests, and company culture. This can constrain choices. And all this assuming that incentives are aligned with shareholders!
In short, corporate leaders operate under bounded rationality by necessity. The good ones know it. Rather than naively trying to compute the uncomputable, they set decision rules, delegate, focus on core objectives, and make the best decision within the limits of time and information.
The Limits of Reason: Why Investors Make Predictable Mistakes
We saw how bounded rationality affects investors and management individually. But what about the effect on millions of market participants?
And so is the reason we have market inefficiencies and mispricings. After all, if every investor were perfectly rational and fully informed, markets would always be perfectly efficient. In reality, investors are human (for now).
So what are some examples? Let’s see:
Overreaction and Underreaction: Investors often overreact to dramatic news and underreact to subtle changes, because our attention and processing power are bounded. A panic-driven selloff on a short-term earnings miss, or conversely a slow appreciation of a company’s improving fundamentals, can leave prices temporarily too low or too high. I discussed these phenomenon on a recent article.
https://www.polymathinvestor.com/p/how-this-micro-cap-stock-soared-37x
Herd Behavior and Bubbles: Bounded rationality can push investors to herd, creating bubbles or crashes. When it’s too hard to independently analyze an asset many simply follow what others seem to be doing. This can inflate prices beyond intrinsic value. The dot-com bubble or the crypto craze are examples of this phenomenon.
Limited Attention and Mispricing: We see this all the time. With thousands of stocks in the market, investors can’t pay attention to all of them. Neglected stocks (often small-caps or out-of-favor industries) may trade at prices that don’t reflect their true prospects because few have analyzed them deeply. This limited attention effect is a direct consequence of bounded rationality – our inability to focus on everything creates pockets of relative ignorance.
The behavioral finance camp of market theory essentially builds on bounded rationality, positing that markets are usually efficient but not always. Market participants’ biases and limits create exploitable inefficiencies. In fact, entire investment strategies are predicated on the idea that because humans have bounded rationality, astute investors can earn superior returns by exploiting the mistakes of others.
So, how can fundamental investors benefit?
Exploiting Inefficiencies: The Art of the "Good Enough" Investment
Understanding bounded rationality isn’t just academically interesting – there are some practical insights for fundamental investors. Here are some ways you can turn the theory into practice:
Simplify Your Decision Framework: At the risk of stating the obvious, don’t drown in data. Identify the few key variables that drive a company’s value (perhaps its revenue growth rate, profit margins, and cash flow generation) and focus your analysis there. Equity analysts call them “critical factors”. Ask yourself for each investment: What 2-3 factors will determine this business’s success? Prioritize those. Even when writing investment thesis, I believe it’s helpful to make explicit which are the critical factors investors should pay attention to track the company’s performance.
Use Checklists and Rules: For the Atul Gawande fans. Checklists are a proven tool to guard against cognitive overload. Pioneered in aviation and medicine to reduce human error, they work for investing too, a many investors develop their on personal chekslists. Creating a pre-invesment checklist forces a moment of rational reflection and can catch mistakes that an overburdened mind might miss. Rules can also help – for instance, setting a rule to never buy a stock without reading at least one annual report, or to automatically trim a position that doubles. Such rules, while simplistic, counteract emotional swings and keep decisions within rational guardrails when markets get chaotic. I have a rule of never investing on a company without reading at least the LTM earning calls transcripts, of course sometimes you end up reading more!
Exploit Others’ Biases: Keep an eye out for situations where market pricing seems driven by emotion or heuristic errors rather than fundamentals. Such scenarios – often revealed through anomalous valuation metrics or insider buying activity – can be golden opportunities for fundamental investors. Essentially, you want to be on the other side of the trade from someone who’s potentially acting under bounded rationality (selling from fear or neglecting to notice value). This is the essence of contrarian and value investing: buy when others are fearful, sell when others are greedy, which aligns with exploiting cognitive biases-driven mispricing.
Lengthen Your Time Horizon: Finally, one way to circumvent the short-term bounded rationality of the crowd is to extend your own decision horizon. Many market participants fixate on the next quarter or the next news cycle (because humans naturally weight the present heavily). By looking out 3-5 years, you can base decisions on more fundamental, slow-moving trends and intrinsic value, where competition is thinner. This doesn’t mean you ignore short-term information, but you put it in context. A dip in earnings this quarter matters less if you believe the company’s long-term thesis is intact. Patience can be a powerful edge because while others zigzag reacting to every headline, you stick with the rational course you charted with the bigger picture in mind.
If you have many years of investing experience, these examples are hardly new to you. Still, I believe that understanding them intellectually is one thing, while truly absorbing them and living and behaving according to them is another—it’s something that could take years.
In all these strategies, the goal is to work with the realities of bounded rationality, not against them. Simplifying does not mean being simplistic – it means structuring your process to filter out noise and emphasize signal.
Conclusion: Embrace the Boundaries to Make Better Decisions
If you are a fundamental investor, I’m sure you are familiar with the concept of the circle of competence. Buffet’s primordial teaching: “You don’t have to be an expert on every company… You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital”.
As we saw, bounded rationality describes three limits for decision-makers: cognitive capacity, information, and time. With this in mind, I’d like to extend the notion of the circle of competence beyond just the information component to also include cognitive capacity and time. Be aware of how much information you have access to, how well you can process it, and how much time you have.
By accepting our cognitive and informational limits, we can make more grounded decisions.
Paradoxically, knowing we can’t be perfectly rational often leads to more rational outcomes because we design strategies and processes to mitigate our weaknesses.
In the end, markets reward those who make slightly better decisions than the crowd, repeatedly. Bounded rationality implies those better decisions won’t come from brute-force analysis of every detail, but from a savvy combination of simplification, insight, and understanding of human behavior.
This underscores the importance of having a checklist. For managers, I would suggest incorporating incentives in addition to rationality guidelines. Relying solely on individual incentives can often lead to decisions that aren't rational from the company's perspective—similar to a doctor recommending surgery even when less invasive measures would suffice.
This post reminded me of the book “The Emotionally Intelligent Investor” when it talks about intuition. This post is especially relevant during a bear market.