Chapter 4 A Fundamental Tool in the Process: Decision Making

1. Chapter 4A Fundamental Tool in the Process:Decision Making The Process of Financial Planning: Developing a Financial Plan Lytton, Grable & Klock 2006

2. Monitoring and Implementation Plan Development Financial Planning Process Decision Making Communication Ethics / Laws / Regulations / Practice Standards Building Block: Financial Planning Pyramid

3. 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

4. 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.

5. 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 prepareclients for the uncertainty of the future “You cannot predict, but you can prepare.”

6. Decision Making: A Generalized Model

7. 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?

8. 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?

9. 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!

10. Step 2: Questions to Ask • Does the decision maker have paradigm paralysis? • Are the alternatives similar, suggesting that the search is exhaustiveor that the decision maker is not open to new ideas? • Do the alternatives address the decision problem or just symptoms of the problem?

11. 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

12. 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 Step 3: Subjective & Objective Criteria

13. Step 3: Questions to Ask • Are the criteria balanced between objective and subjective? • Which criterion will have the greatest impact? • Which alternative is least costly or offers the greatest benefit? • Which alternative best matches decision maker’s values, goals, and available resources?

14. 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)

15. 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

16. Step 4: Questions to Ask • Was the choice based on intuition, fact, or a combination? • Was the choice, implementation, or process affected by procrastination? • Were evaluative criteria identified that reflect objective and subjective issues that characterize the decision and its significance?

17. 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

18. Step 5: Questions to Ask • What can you learn? • From the situation? The outcome? • Ahhhhh….hindsight • What information would have been useful? Changed the process? Changed the outcome? Was the information available and not included? • The future… • How should you change the process?

19. A Generalized Model of Decision Making

20. Decision Rules for Choosing Among Alternatives

21. The Traditional Approach to Decision Making • Economic Roots • Probabilities • Objective & subjective • Models • Stochastic modeling • Deterministic model

22. 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

23. 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 Probabilities: Objective & Subjective

24. Stochastic Modeling Mathematical projections that account for multiplevariables 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 Models: Stochastic vs. Deterministic

25. Example: Traditional Decision Making Approach

26. 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

27. Behavioral Finance: Shefrin’s Three Basic Themes • Financial professional rely on heuristics when making decisions. • The way a scenario is framed can change a practitioner's perception of the risk and return involved in a decision. • Markets are influenced by the way financial professionals make decisions; the markets are inefficient because decisions are based in part, on cognitive biases.

28. Behavioral Finance: Biases and Misjudgments • Heuristics • Representativeness • Framing • Aversion to loss • Regret avoidance • Overconfidence bias • Mental accounting

29. 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

30. 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

31. 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!

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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!

41. 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?

42. 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!

43. 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.

44. 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

45. 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

46. 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