Herbert Simon
The Nobel laureate (1978) credited with Bounded Rationality — the idea that investors, limited by time, information or ability to process it, settle for a "satisficing" choice rather than the optimal one.
In plain language
Standard finance assumes investors work through every option and pick the best one. Herbert Simon is the economist the workbook credits with showing why that rarely happens in practice.
Simon's idea, Bounded Rationality, says decision-making is limited by real constraints: not enough time, not enough information, or not enough ability to process complex information all at once. Faced with those limits, people do not optimise. They satisfice — settle for an option that is good enough.
How it works
The workbook credits Nobel laureate Herbert Simon (1978) with the concept of Bounded Rationality, and sets out its three steps:
- Process only manageable information — not everything available.
- Apply rules of thumb or quick approaches while processing it.
- Select a "satisficing" solution — one that is satisfactory and sufficient, rather than optimal.
"Satisficing" is the workbook's own coined blend of satisfactory and sufficient. Bounded rationality is explicitly not irrational decision-making; it is rational decision-making within real boundary conditions of time, information and processing ability.
The workbook places Bounded Rationality between two other ideas on the same spectrum: full rationality, which processes all available information to reach the optimal solution, and pure intuition, based on experience alone. Bounded rationality sits in between.
A worked example
Illustrative figures. Mr Naidu has Rs 20,00,000 to invest and, in principle, could research every mutual fund scheme in India before deciding. Comparing all of them properly would take weeks he does not have.
Instead, following Bounded Rationality's pattern, he narrows the field using a quick rule of thumb — schemes rated 4 stars or higher by a well-known rating agency, with at least a 5-year track record — and picks one from that shortlist that feels good enough for his goal, without comparing every fund in the category in full detail.
He may not have found the single best-performing scheme in India. But his decision was not irrational: given his real limits on time and his ability to process hundreds of scheme documents, a satisficing choice, made through a sensible shortcut, is exactly what Bounded Rationality predicts and does not criticise.
Why NISM asks about it
Chapter 16 (Basics of Behavioural Finance), section 16.2.1, "Bounded Rationality," credits Herbert Simon (1978) by name and sets out the three-step process and the satisficing concept. Expect a question naming Herbert Simon and Bounded Rationality together, and a conceptual question distinguishing bounded rationality from irrational decision-making.
Common exam traps
- Bounded rationality is not irrationality. The workbook is explicit that it is rational decision-making under real constraints, not a synonym for making bad choices.
- Herbert Simon (1978) is a separate Nobel laureate from Daniel Kahneman (2002) and Richard Thaler (2017), credited with a different concept from the same chapter — a common mix-up in recall questions.
- "Satisficing" combines satisfactory and sufficient — it is the workbook's own term, not a typo for "satisfying."
- Bounded rationality sits between full rationality and pure intuition on the workbook's own spectrum, not at either extreme.
Check yourself
1.Which statement about bounded rationality is correct?
- a)It is rational decision making under certain boundary conditions, not irrational decision making
- b)It is a form of irrational decision making caused by emotional bias
- c)It requires processing all available information before selecting the optimal solution
- d)It falls outside the range between rationality and intuition
Show the answer
Answer: (a) It is rational decision making under certain boundary conditions, not irrational decision making
The workbook is emphatic: bounded rationality is not irrational decision making, but rational decision making under certain boundary conditions.
It arises from three limits at the time of decision making: time, information, and ability to comprehend complex information. It leads to a satisficing solution rather than an optimal one, and it falls between rationality and intuition. The concept is credited to Herbert Simon (1978).
2.Who identified the disposition effect, and in which year?
- a)Shefrin and Statman, in 1985
- b)Kahneman and Tversky, in 1979
- c)Herbert Simon, in 1978
- d)Richard Thaler, in 1999
Show the answer
Answer: (a) Shefrin and Statman, in 1985
Shefrin and Statman (1985) extended the analysis of loss aversion to the investing field and identified the disposition effect — the tendency to hold the losers too long and sell the winners too early.
Keep the attributions apart: loss aversion bias is Kahneman and Tversky (1979), arising from their work on prospect theory. Bounded rationality is Herbert Simon (1978). Mental accounting is Richard Thaler (1999).
Where this is taught
Free preparation for NISM Series X-BRelated terms
- Daniel KahnemanThe Nobel laureate, with Amos Tversky, behind Prospect Theory — the framework the workbook uses to explain how investors actually weigh gains and losses, unlike the rational-actor assumption of standard finance.
- Reference pointIn Prospect Theory, the baseline of well-being against which an investor evaluates every choice as a gain or a loss, rather than judging outcomes against total wealth in absolute terms.