Thursday, November 24, 2011

How to Make Good Decisions

Contrary to what some of you might think, understanding how people make decisions is an important aspect of successful investing and is thus very relevant to the main thrust of this blog. If we think about it, "investing" really is just a series of "buy" and "sell" decisions, specifically: what assets to buy or invest in, when to invest, and eventually, when to sell. Also, understanding the psychology of the typical investor--how the "crowd" thinks and how it reacts to shocks and new information--is key in devising an effective investment strategy. Finally, the ideas that I present and discuss in this space may actually also be applied to decisions of all kinds, from the mundane (e.g., how to decide which pair of pants to wear today) to the fun (e.g., whether to call, raise, or fold) to the life-changing (e.g., how to choose a wife).

Our aim in discussing and learning these concepts is, first and foremost, to become good decision makers. A good decision is one that is based on logic, and considers all available data and possible alternatives. Please do take note that by "good decision," I don't necessarily mean "the right decision" as no matter how well or systematic one goes through the decision making process, outcomes may still be unexpected or unfavorable. But regardless of the outcome, a decision that is "made properly" is still a good decision.

Normative vs. descriptive decision theories

There are two main approaches in studying decision making: the normative approach and the descriptive approach. The normative or prescriptive approach delves into how people are supposed to make decisions, assuming they are fully informed, able to compute with perfect accuracy, and fully rational--characteristics of an "ideal" decision maker. This approach is generally quantitative in nature and is heavily based on the academic fields of mathematics, operations research, and economics. And because the underlying assumptions of this approach are ultimately unrealistic, many find its associated theories to be of little practical import.

The descriptive approach, on the other hand, deals with how people actually make decisions; it covers the ideas that we have discussed in the Pop Quiz post and is the basis for many important developments in behavioral finance and economics. Descriptive decision theories are mainly based on behavioral and psychological concepts and usually rely on experimental evidence for support.

How does one actually make "good" decisions?

While there is no foolproof way of always getting the best outcomes, it is possible to always make decisions that make sense. Good decisions are those that (roughly) follow these steps.

1. Identify all available alternatives. In poker, each decision stage may be broken down to the following choices: give up and fold, call or meet the current bet, or raise the bet. In most real life situations however, alternatives are not as obvious and clear cut as that; it therefore pays to spend some time to figure out all the alternatives you may choose from, maybe even after some form of initial screening. Nothing is worse than failing to consider what would later turn out to be the best alternative (or even just a really good one).

2. Determine the costs and benefits of alternatives. In finance, when we choose between stocks and bonds, for example, we consider the trade off between the risk of a loss and potential returns. The same is true of most other cases: alternatives entail rewards and costs that we both should consider in making our choice.

3. Identify uncontrollable or unpredictable circumstances that may affect the payoffs of alternatives. What makes decision making so complicated is that it often involves uncertainty, usually about something that may happen in the future that will affect the value of our alternatives. In poker, it is the chance that the river card is a heart that will complete our flush. In investing, it is the possibility that policy makers in the Eurozone will finally get their act together and give stock markets around the world some much needed breathing room. The tricky part is that it is often not enough to know what may happen; most times, having some measure of the likelihood that something will happen is even more important.

4. Evaluate alternatives using some criteria or rule and make a decision. Normative decision theory tells us to use criteria like "expected value" or "expected utility" in making decisions; descriptive decision theory shows us that we don't actually like using these criteria, but rather rules of thumb or heuristics. In most cases, the specific criteria or rule that you use does not matter--as long as you use one. Ultimately, having some basis for making a choice is what separates good decisions from the bad.

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