Investments and Asset Pricing in a World of Satisficing Agents

Tony Berrada, Peter Bossaerts and Giuseppe Ugazio
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Peter Bossaerts: University of Cambridge

No 24-05, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: 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 modeling approach not only by pointing to benefits of robustness (robust control), but also with reference to recent developments in behavioral economics and decision neuroscience.

Pages: 33 pages
Date: 2024-01
New Economics Papers: this item is included in nep-hme and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2405

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