We are brought up, at least in school and MBA class if not at home, to believe we should adopt a process of rational decision making, in which objectives are defined, alternatives are formulated and laid out, and probabilities attached to outcomes.  We know that we don’t really do this, and that the institutions which come closest to it – public agencies and large corporate bureaucracies – either fail to make good decisions, or only pretend to follow this model of rationality, or often both.

       We generally don’t make decisions that way because we can’t.  The world is characterised by such fundamental uncertainty that we don’t usually know, even with hindsight, whether decisions were good ones:  and if that is the case, how can we expect to know in advance what decisions are good ones?   What do we mean by a good decision anyway?   Did the person who bought the winning ticket in a lottery make a good decision?   And the uncertainties we face are mostly not the ascertainable probabilities of a lottery.   We don’t know what might happen, far less the likelihood that it will.

       In reality, we – rationally – apply a variety of strategies to ‘cope’ with uncertainty.  The pragmatic decision making we engage in uses probabilities, but more often tells stories:  allows our feelings to influence, but not control, our actions:  uses models, but doesn’t believe they describe the world:  employs heuristics, emphasises habits and routines.  The ‘mistakes’ behavioural finance identifies are typically the result of sensible rules being applied in artificial situations which have been constructed in order to deceive.

       I used to teach students that they had to believe in the models of rational behaviour standard in finance theory because, if they didn’t, people would devise strategies to make money at their expense.   I now believe that is exactly what happens.  So I’ll end with some practical lessons.