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Chapter 4A Fundamental Tool in the

Process:Decision Making

The Process of Financial Planning:

Developing a Financial Plan Lytton, Grable & Klock

2006

Building Block: Financial Planning Pyramid

Plan Development

Monitoringand

Implementation

Financial Planning Process

Decision Making

Communication

Ethics / Laws / Regulations / Practice Standards

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Decisions vs. Habits?

Decisions • Reflect a choice, resolution or conclusion arrived

at after a consideration of alternatives.

• Are conclusions based on fact, emotion, assumptions, conjecture, interpretation, or a combination of these and other factors.

Habits• Avert conscious decision making through routine

selection of the same choice every time

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What is Decision Making?

The dynamic process of defining the problem or issue to be decided, identifying the alternatives, clarifying the criteria on which the alternatives will be evaluated, reviewing the alternatives, making the choice, taking action, and evaluating both the outcome and the process.

“Good” vs. “Bad” Decisions? Don’t confuse the process with the result!

The problem is humans equate the success of the decision process with the outcome.

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Why Study Decision Making?

Planner-client relationships. . .• Fiduciary or trustee relationships

• Professional or regulatory codes of conduct

. . . require defensible decision making practices• To build solid planning practices (CYA!)

• To prepare clients for the uncertainty of the future

“You cannot predict, but you can prepare.”

Decision Making: A Generalized Model

1. Recognize need to make a decision: Prompted by question, behavior, concern, problem, or goal

2. Identify & research alternatives in response to the question, behavior concern, problem or goal

3. Consider & rank the alternatives relative to the established criteria

4. Choose an alternative and implement the alternative

5. Evaluate the outcome & the decision making process

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Step 1: Recognize & Define

Recognize the Need to Make a Decision and Define the Question, Behavior, Concern, Problem or Goal

(Threat or Opportunity?)

1. Is the issue longstanding or is it a short-term event?

2. Is the issue self-correcting?

3. If nothing is done, will harm occur?

4. If something is done, will benefit occur?

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Step 2: Identify & Research

Identify and Research Alternatives in Response to the Question, Behavior, Concern, Problem, or Goal

The search – potential solutions and strategies• Approach: intuitive or formalized

• Varies with knowledge, experience, familiarity with an issue

• Willingness to conduct a search that might introduce new alternatives?

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Step 2: Identify & Research (cont’d)

Number of alternatives• How important is the decision?

• More alternatives may equal difficulty or confusion when processing alternatives

• Identifying alternatives that represent a wide range of appeal may reduce confusion

The greater the potential for a negative consequence, spend greater effort to

develop alternatives!

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Step 2: Questions to Ask

1. Does the decision maker have paradigm paralysis?

2. Are the alternatives similar, suggesting that the search is exhaustive or that the decision maker is not open to new ideas?

3. Do the alternatives address the decision problem or just symptoms of the problem?

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Step 3: Consider & Rank

Consider & Rank the Alternatives Relative to the Established Criteria

The decision maker must• Consider the subjective and objective criteria

• Identify the most important criteria for decision

• Rank the alternatives – relative to the set criteria

Most difficult step in the process

Step 3: Subjective & Objective Criteria

Subjective

Factors include: tastes preferences values, attitudes, beliefs needs, wants assumptions morals or ethics

Objective

Factors include: resource availability costs and benefits of

alternatives attributes of alternatives projections on probability

of outcomes or assumptions

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Step 3: Questions to Ask

1. Are the criteria balanced between objective and subjective?

2. Which criterion will have the greatest impact?

3. Which alternative is least costly or offers the greatest benefit?

4. Which alternative best matches decision maker’s values, goals, and available resources?

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Step 4: Choose & Implement

Choose an Alternative & Implement It

An optimal choice is often impossible, given uncertainty, but a selection must be made that• Seems best and will reduce doubt and anxiety!

Choices• May result from conscious deliberation

• May result from intuition: “just knowing” or a “gut reaction”

• May be positive, negative, or neutral (e.g., no action)

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Step 4: Implementation Without implementation…

…a decision = a desire

Timing of the implementation varies with the• Severity of client’s situation

• Importance placed on the need to improve the situation

• Resources available to meet a need

Identify evaluative criteria• Assess success or failure of the decision and the decision

process

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Step 4: Questions to Ask

1. Was the choice based on intuition, fact, or a combination?

2. Was the choice, implementation, or process affected by procrastination?

3. Were evaluative criteria identified that reflect objective and subjective issues that characterize the decision and its significance?

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Step 5: Evaluate

Evaluate the Outcome & the Decision Making Process

Assess outcomes• Positive, negative, or neutral

Make adjustments for the future• Monitor the process and outcomes of previous decisions

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Step 5: Questions to Ask

1. What can you learn?• From the situation? The outcome?

2. Ahhhhh….hindsight• What information would have been useful? Changed the

process? Changed the outcome? Was the information available and not included?

3. The future…• How should you change the process?

A Generalized Model of Decision Making

1. Recognize need to make a decision: Prompted by question, behavior, concern, problem, or goal

2. Identify & research alternatives in response to the question, behavior concern, problem or goal

3. Consider & rank the alternatives relative to the established criteria

4. Choose an alternative and implement the alternative

5. Evaluate the outcome & the decision making process

Decision Rules for Choosing Among Alternatives

Maximize

Choose outcome with highest unadjusted result Assumption: best possible outcome of the alternative will occur

Optimize

Alternative to maximizing Used when all relevant goals, data, and resources are known and more than one alternative is available Assumption: all alternatives are identified and feasible

Satisfice “When is good, good enough?” Satisfy as many criteria as possible while sacrificing other criteria

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The Traditional Approach to Decision Making

Economic Roots Probabilities

• Objective & subjective Models

• Stochastic modeling

• Deterministic model

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The Traditional Approach to Decision Making (cont’d)

Economic roots• “Rational man” theory

• Assumed likelihood of an alternative can be estimated using probabilities

Conditions• Certainty

• Individual outcomes do not have 100% chance of occurring, BUT decision maker has a 100% chance of predicting the correct outcome

• Uncertainty • Individual outcomes do not have 100% chance of

occurring, AND Decision maker does not have 100% chance of correct prediction

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Probabilities: Objective & Subjective

Objective

Know with some certainty

Based on experience, experiments, or results of research or study (large samples)

Ex. mortality probabilities

Subjective

Based on person’s belief or best guess of the likelihood of event actually occurring

Ex. market prediction based on history repeating itself

Models: Stochastic vs. Deterministic

Stochastic Modeling

Mathematical projections that account for multiple variables

• ex. mean and SD

Inputs randomized within a certain range

• model can account for variations & timing of returns

New branch of traditional decision making theory

Static inputs

Deterministic Model

Mathematical projections that account for only one variable

• ex. return

Uses averages

• does not account for the fluctuation of timing or returns

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Example: Traditional Decision Making Approach

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The Behavioral Finance Approach to Decision Making

Prospect Theory• Kahneman & Tversky (1979)

• Many credit as the establishment of serious study of behavioral finance

• Origins actually traced back to 1950s

What does behavioral finance do?• Attempts to bridge gap between the solely

economic model of utility and the more psychological model of value

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Behavioral Finance: Shefrin’s Three Basic Themes

1. Financial professional rely on heuristics when making decisions.

2. The way a scenario is framed can change a practitioner's perception of the risk and return involved in a decision.

3. Markets are influenced by the way financial professionals make decisions; the markets are inefficient because decisions are based in part, on cognitive biases.

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Behavioral Finance: Biases and Misjudgments

Heuristics Representativeness Framing Aversion to loss Regret avoidance Overconfidence bias Mental accounting

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Behavioral Finance: Biases & Misjudgments (cont’d)

Mental accounts House money Gambler’s fallacy Hot hand fallacy Regression to the mean Ignoring the base rate Herding

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Heuristics: Threat to Probability

What are they?• People use their experiential knowledge to

reduce complexities into simpler judgments

• Common sense knowledge leads to mental shortcuts

Heuristic tool example of retirement planning:100 – Client’s Age = % of the Portfolio in Equities

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Heuristics: Threat to Probability

As subjectivity increases, accuracy declines: the misconception of chance

Representativeness/stereotype• Problem: Frequency of occurrence

Illusion of validity

Heuristics offer benefits! But they must be challenged, especially for

important decisions!

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Framing

Framing of a question, case, or scenario can influence the way a person arrives at a decision

When does it happen?• By framing the context of the choice by considering

possible outcomes from a particular perspective that represents a set of norms, habits, or personal characteristics

• When a provider of information frames or alters the context of information in such a way as to influence the decision maker

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Which Would You Choose?

Take a sure loss of $750 OR Take a 75% chance where you will lose

$1,000 and have a 25% chance of losing nothing

Take a sure gain of $750 OR Take a 75% chance where you will gain

$1,000 and have a 25% chance of gaining nothing

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Aversion to Loss

People dislike losing significantly more than they like winning

Aversion for losing is stronger than the attraction of winning

People are not rational when making certain decisions

Improving financial decisions = taking into account planner’s and client’s

cognitive biases

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Regret Avoidance

Behavioral bias – decision makers who make decisions to minimize the negative effect of making a bad or wrong decision

The result?• Stick with the status quo – no change

• Avoid the decision – no change

• Uncomfortable with the change

• Constantly checking the status of the change

• First sign of bad news – go back – “undo” the change

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Overconfidence

Overestimate their own abilities (or success) and underestimate the abilities of others (or failure)

Individuals believe they can control random events simply by obtaining more knowledge and familiarity with a situation

Overconfident investors• Tend to trade too much and earn lower returns due to

increased tax liability and commissions

• More likely to subject themselves to substantially risky decisions

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Mental Accounting

People tend to separate and categorize money into different mental accounts

Way to reduce feelings of regret associated with gambling and investment loss (e.g., house money)

Also prevents a “global” approach to money management that can lead to increased risk exposure

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Gambler’s Fallacy What do I deserve after a run of bad luck?

• Good luck!

They believe, if an outcome is repeated over time, it is followed by the opposite outcome.

• Why? Poor understanding about the outcomes of random events

Regression to the mean

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Hot Hand Fallacy Accidental success = the result of skill

• Example: confusing a rising stock market with being a expert investor

• “It is better to be lucky than good!”

Problems: Overconfidence in one’s own abilities AND overestimating the representativeness of the situation

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Regression to the Mean

Statistical phenomenon – actually applies to numerical data such that abnormal results tend to be followed by more average results (or at least average out over large number of attempts)

Bias: extrapolate from recent information far into the future and ignore the reality of regression to the mean!

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Ignoring the Base Rate

Tendency to disregard overall likelihood of a certain outcome

• Example: momentum investing which can drive markets higher or lower than even a rationale model would predict

Steve: shy, helpful, little interest in people, meek, tidy, organized, detail-oriented. His occupation –salesman or librarian?

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Herding

Tendency of animals, including people, to group together for protection

If I’m going to be wrong, I’d rather be wrong in a group, and if the group is going to be right, don’t leave me behind!

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Behavioral Finance Theory:Assumptions

When making investment & financial decisions:

• Most people do not act in consistently rational ways.

• They cannot accurately predict the consequences of their choices.

• They are loss-averse and feel regret when outcomes are not as anticipated.

• They can be influenced by contextual changes in the presentation of information – maybe the most important consideration.

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Threats to the Decision Making Process

Complacency• A person either cannot or chooses

not to see approaching danger

Defensive avoidance• A person acknowledges a danger,

but tends to deny the importance of the danger or the potential role of individual responsibility to reduce the danger

• Procrastination

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Threats to the Decision Making Process (cont’d)

Panic reactions• When people are faced with a threat

that they believe is too urgent to solve using the decision making process

PANIC• Frenzied search for solutions; little

evaluation; too much action; little follow-through

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Summary

Don’t label, but understand! Use the generalized model of decision

making Both advisors and clients should understand

and explore cognitive biases and threats to decision making

Strive to integrate decision making logic with illogical behavioral influences