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How Thinking
Affects Investing

Bounded Rationality

To invest well requires us to predict the future. Strictly speaking, this is impossible because the stock market is inherently unpredictable. Nevertheless, over the long run, it is possible to make money, if we can fulfill all of the following requirements:

1. We must know what we are doing.
2. We must make good decisions.
3. We must think rationally.
4. We must be lucky.

As straightforward as this seems, it is difficult to do, because of natural limitations beyond our control, a concept economists refer to as BOUNDED RATIONALITY.

Bounded rationality asserts that our potential to make the best-possible decisions is limited in three important ways:

First, we are limited by the amount of information that is available to us. No matter how much knowledge we are able to acquire and understand, our information will always be incomplete.

Second, we are limited by our ability to think well. No matter how smart we may be, and no matter how logical we try to be, we are still creatures of habit, emotion, and intuition. As such, we are susceptible to the problems created by the heuristics and cognitive biases. Thus, it is impossible for a human being to think comprehensively and rationally under all circumstances.

Finally, we are limited in that every decision we are called upon to make must be carried out in a finite amount of time.

Because of the limitations imposed by bounded rationality, there is a pattern of action that will tempt you: a trap I want to make sure you avoid.

When you are faced with a complex and difficult situation, it is common to feel uncomfortable. This is normal. It is a warning that you do not have the information, the expertise, and the time to make an optimal decision.

What many people do in such circumstances is to over-simplify the issues to the point where they can make a decision, even if it doesn't make sense. To do so, they will manipulate themselves and the people around them, unconsciously, so as to simplify the details and the possible choices they are facing. It is only then — after they have fooled themselves into thinking the situation is easy to understand — that they begin to apply logical thinking (with predictably negative results).

As an example, it is common for companies that receive many applications for a job to use arbitrary criteria to narrow the field. For instance, a company with 200 applications for a single job might consider only those people whose resumes were no more than one page long. Although this is not a particularly good strategy, it does reduce the applicant pool quickly, making the job-hiring process a lot easier.

Consider another example. An investor has a portfolio consisting of several hundred shares in each of 10 different stocks. He needs to sell some of the shares within the next week to pay his son's college tuition. Trying to figure out which stocks to sell, and how much, quickly overwhelms him. There is simply too much information for him to analyze in a week.

However, a friend with business experience happens to mention that, in his experience, young CEOs often have trouble growing a company past a certain size. The investor checks each of the 10 companies and finds that three of them have CEOs younger than 50 years old. He then looks only at those three companies, focusing on which of the three stocks is the best one to sell. It may not make sense, but it helps him narrow down the choices.

Being human, we will never escape the limits of bounded rationality. As a result, we must accept the idea that we will often be called upon to make investment decisions we can't fully understand. Nevertheless, in such situations, we must avoid the temptation to make decisions foolishly, just because doing so is easy.

There are no simple solutions to the problems caused by bounded rationality. The best advice I can give you is to simplify only in a way that makes sense — and then respect your limitations.

Harley's Rule of Investing #10

Sometimes good enough is good enough.

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