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The Concept of Bounded Rationality in Decision-making

Bounded rationality represents a class of rational decision-making approaches that describe how humans actually make decisions in specific contexts (e.g. VCs' investment decisions), in comparison to theoretical models of ‘rational optimization’. Thus, a gap exists between normative decision-making models and actual behaviour.

Bounded rationality models recognize that an individual’s decision-making is limited by cognitive and environmental factors, including: his/her cognitive abilities1 (rather than some assumed “Laplacean superintelligence” (Gigerenzer & Selten, 2001: 37, 263)), the information possessed or easily accessible, and the finite amount of time available to make the decision. Confronted with a complex and uncertain world and often novel environments (such as characterize both entrepreneurship and new venture investing), decision-makers in such contexts have a propensity to simplify in attempting to make sense of it all. They seek means of “distill[ing] masses of information into understandable bites” (Maital, 2004: 7) and develop cognitive structures or mental models which include knowledge (and biases) acquired and processes learned over their life-to-date, together with frameworks modelling how these elements interrelate for a specific context. Mental models serve as guides for understanding, decision-making, and acting, as well as scanning & filtering the environment for new information and the identification & evaluation of alternatives (Maitland & Sammartino, 2015: 738). Each person’s mental models evolve over time as a result of new experiences and social interactions and are therefore unique. Accordingly, “variance in mental models” contributes to entrepreneurial management team (‘eMT’) member diversity which manifests in “variances in what individuals perceive and decide … ultimately shaping firm-level strategic choices, growth and performance” (ibid.)

Boundedly rational decision-makers simplify the choices (alternatives) and the process (by using heuristics) and seek satisfactory solutions (e.g. surpassing an ‘aspiration level’3,4) rather than necessarily optimal ones (Gigerenzer & Selten, 2001; Ch. 1). According to Gigerenzer, a fundamental aspect of bounded rationality models of decision-making under conditions of uncertainty is that the desire for optimization is abandoned.

In the vernacular of Gigerenzer & Selten (2001: 8), decision-makers use “fast & frugal heuristics”5 to simplify decision-making and ‘get on with it’. By incorporating fast and frugal stopping rules when searching for relevant information, bounded rationality avoids problems of infinite regression. Gigerenzer promotes bounded rationality as the key to understanding how real people make decisions and highlights that while it is neither optimization nor irrationality, its departure from rationale decision theory should not render it an inferior form of decision-making.

Research in VC investment decision-making suggests venture capitalists are boundedly rationale. But, as Gigerenzer & Selton propose, this is not necessarily a bad thing. It does mean, however, that VCs can use help understanding their boundedly rationale processes and researchers should focus on investigating such opportunities to help. For more insights on the elements of bounded rationality and heuristics tools & mechanisms, please consult the full article.

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