4. Bounded Rationality in Strategic Decision Making
4.4 Behavioural Finance and Behavioural Strategy
Other information required would be the uptake of the technology by other businesses, the popularity of the technology and the technology maturity levels. Decision makers will have to understand the market dynamics by which maturity or popularity has been achieved and the buying processes followed, such as market research, supplier comparisons, product walk- throughs and reference sites, as well as understand how the information from these information searches were used (Banerjee & Fudenberg, 2004).
Several researchers (Alm, 2010; Lovallo et al., 2009; Thaler & Sunstein, 2008; Camerer et al., 2005; Camerer et al., 2003) defined behavioural economics/finance/strategy as the use and application of social cognitive and emotional factors, methods and evidence from such social science disciplines such as psychology to economics/finance/strategy, in order to inform the analysis of individual and group decision making (including borrowers, investors, consumers, gamblers, politicians and businesses) and its effects on market prices, returns, resource allocation, political and strategic choices. The primary facet of concern is the bounds of rationality (selfishness, self-control, etc.) of economic agents.
Behavioural strategy departs from the approach of rational value maximisation by borrowing from the psychology of decision making to offer a more realistic depiction of the behaviour of real people. Advances in cognitive psychology, behavioural finance and behavioural economics have shown that there are many instances where emotion, bias and other extraneous influences affect decisions and strategic choices (Thaler, 1999), thereby explaining some of the irrationality and irregularities that conventional strategic theories have failed to explain.
According to Alm (2010) and other researchers (Thaler, 1999, 1992, 1991; Lovallo, 2009), there is growing acceptance that:
Human beings are affected by the ways in which options are ―framed‖ (e.g., anchoring, loss aversion).
Human beings‘ computing ability is not limitless (e.g. framing effects, George Ainslie's hyperbolic discounting, mental accounting, etc.).
Human beings systematically miscalculate the true value of their actions (e.g. The Winner‘s Curse by Richard Thaler, 1992).
Human beings are not always self-serving (e.g. communalism, morality, justice, etc.).
Human beings have limited willpower, and
Human beings are influenced by the process, the environment and the context in which decisions are made.
These advances offer insights into business – people are not always rational and because people carry with themselves their biases, beliefs, values and rationality into their work
environments, business executives, and consequently businesses, will not always be rational when making strategic decisions (Botzen & van den Bergh, 2009). Left unchecked, subconscious biases will undermine strategic decision making. The abilities and skills that determine the quality of strategic decisions and the creation and solution of problems and opportunities are stored in the minds and hearts of real people, as well as organisational memories and cultures.
Behavioural economics, behavioural strategy and behavioural finance have been proven in a number of studies, based mostly on laboratory experiments (Thaler, 1999; Alm, 2010, Lovallo &
Sibony, 2006). A number of studies have also investigated the phenomena in single project settings, where decision makers had to select among competing project alternatives (Flyvbjerg et al., 2009; Lovallo et al., 2009), or select specific attributes and parameters within a project.
Yet a number of research studies have concentrated on explaining and arguing for the acceptance and application of behavioural concepts (Lovallo & Sibony 2006; Finkelstein et al., 2008; Foss, 2003, Teece et al., 2002; Hite, 2003; Bromiley & Flemming, 2002, Barberis, et al., 2001, Barberis & Huang, 2001). Application of bounded rationality principles in real life settings is still limited (Magni, 2009).
In their study of the tracking error of financial market equilibrium, Berg and Gigerenzer (2007) and Todd and Gigerenzer (2000) concluded that behavioural economics and psychology are engendering better decisions, but whether such violations of rationality are beneficial and in which contexts, remains debatable. In his article entitled, ‗The End of Behavioral Finance‘, Thaler (1999:15) came to the conclusion that ―we can enrich our understanding of financial markets by adding the human element‖. Magni‘s (2009) recommendation for further studies hoped for more views on the interrelationship between bounded rationality and standard economics and finance, stating that the two should not be treated as ―rivals‖. Gigerenzer and Regier (1996) argued for the non-distinction of the two systems, arguing that the separation is artificial and only useful as a metaphor. Thus a study of a real life situation on the cooperation of bounded and unbounded rationality is long overdue.
In their paper, ‗The Case for Behavioral Strategy‘, Lovallo and Sibony (2006) argued that business executives are aware of cognitive biases in decision making, yet choose to ignore them. These two, with several other researchers in the field (Flyvbjerg et al., 2009; Finkelstein
et al., 2008; Foss, 2003), have argued how bounded rationality in decision making is an integral part of strategic management. These theories have emphasised the uniqueness in firms (organisations and organisational actors differ), in terms of their aspirations, their knowledge, and their decisions. According to Lovallo et al. (2009), the most basic contribution of the behavioural theory of the firm to strategy is the recognition of the fundamental importance of firm heterogeneity, with firm heterogeneity leading to performance heterogeneity within an industry. The idea that firms are fundamentally heterogeneous, in terms of their internal knowledge, skills, and resources, is at the heart of the field of strategic management (Porter, 1980).
These findings suggest that there is merit in merging the normative and the behavioural-based models of decision making. This is an important concept to understand when dealing with a problem such as climate change, as it involves multiple stakeholders, a multitude of diverse information from diverse backgrounds (climatology, science, economics, sociology, etc.) and seeks to address multiple objectives. All of these actors address problems and their solutions based on their own biases, their world-views and/or organisational structures.