Theory Workshop - Peter Bossaerts (Cambridge)

Title: “Investments and Asset Pricing in a World of Satisficing Agents” (with Tony Berrada & Giuseppe Ugazio)

In 1955, Herbert Simon proposed that economic agents do not optimize, but instead satisfice: they optimize up to some point of satisfaction. But Simon did not provide a formal model. Here, we develop a formal theory of a satisficing investor and consequent financial market equilibrium borrowing a technique from robust control in engineering, namely, Model Reference Based Adaptive Control (MRAC). Instead of optimizing a portfolio in terms of, say, a mean-variance trade-off, the MRAC agent chooses portfolios that generate return distributions that minimize surprise with respect to a desired reference distribution. Surprisingly, the satisficing agent mostly acts ``as if'' optimizing, but we discover important -- and realistic -- deviations, such as willingness to accept risk even in the absence of a risk premium. This also implies that asset pricing may at times differ substantially from traditional theory. We motivate our modelling approach not only by pointing to benefits of robustness (robust control), but also with reference to recent developments in behavioural economics, decision neuroscience and computational neuroscience, thus going beyond what was known in psychology at the time Herbert Simon proposed his model of human behaviour.

Read the paper here