Coaching Business Choices

Business Choices: Gaining Insight into Uncertainty and Risk

Executives at every level in business are faced with daily decisions that affect both internal and external company issues. Given the facts surrounding their decisions are correct, managers and employees try to determine the correct course of action for their respective areas of responsibility. The issues are numerous and some have direct impact on everything from top-line revenue growth to employee quality of life. Due to a series of new external circumstances that have evolved in recent years, such as terrorism or bio threats, decisions that are being made have to be decided with new concerns of uncertainly and risk. How are these decisions analyzed and to what degree is uncertainly acceptable within the decision-making process?

It is important to accurately define the terms of “uncertainty” and “risk” prior to continuing the discussion. Webster’s defines uncertainty as “the state of being uncertain; doubt; hesitancy”. The dictionary also defines uncertainty as “unpredictability: indeterminacy or indefiniteness” which better fits the concept being discussed. More accurately defined, uncertainty is an event or outcome that is not certain but may or may not happen. When uncertainly is quantified through empirical observations, it is perceived to be risk.1

Risk can therefore be defined as uncertainty associated with an event that can quantified on the basis of casual knowledge. Frequencies and probabilities are considered ways to express risk. But unlike the term in its everyday usage, the term “risk” need not be associated with harm. It can refer to an event which is considered positive, neutral, or negative.2

While recently working with another consultant, a decision had to be made concerning the issue of payment by a joint client. It was known that the client was under-financed and the work that was being requested would require terms to be given by both consulting practices. The question then became how certain was it that both consultants would be paid and how timely would the payments be? Was the amount of effort that was to be expended on behalf of the client worth the risk of non-payment for the services to be rendered? It became necessary to make list the associated probabilities of payment based on history, account assess, a general assessment of the account’s present circumstances, the relationship with the client by both consulting practices, payment process, and finally effort toward the client’s project implementation.

A value heuristic was used to determine the uncertainty. This heuristic is one of the procedures that may be used to retrieve, interpret, and evaluate information based on specific situational characteristics and personality biases. This is generally perceived to be less accurate and can lead to systematic errors in the decision-making process3 which is what indeed occurred. Both consultant’s wanted the additional revenue and agreed to the extended payment terms that eventually resulted in payment for services rendered extended over a much longer time period than originally quoted or expected. This effectively caused cash flow issues for both consulting firms because the risk was improperly evaluated or quantified. The psychology of making a prediction should be considered to provide a realistic probability of a perceived outcome. There are three different types of information that are relevant to statistical prediction: 1) previous or background information that has been acquired; 2) specific evidence that concerns the individual account or case at hand; and 3) the expected accuracy of the prediction. A fundamental rule that should also to be taken into consideration when using statistical prediction is that “expected accuracy controls the relative weights assigned to specific evidence and to prior information”.4

The weights that were assigned to the prior information of payment history were not correct, making the prediction of timely payment terms inaccurate. Neither consultant properly evaluated the risk involved in the completion of the project for the client. Had a numerical prediction been applied to the situation, a better and more complete understanding of the risk would have been provided as well as further evidence for proceeding based on the uncertainty that the client would pay within terms.

In fact, both consultants took a chance that the payment would be timely. This misconception happened because a sequence of prior events led to the belief that although the client had paid slow in the past, additional funding was expected. The payment did occur, but it took longer to receive than anticipated.

Chance is a form of clouded thinking which can be further understood as a form of innumeracy in which a person knows about the risks but not how to draw conclusions or inferences from them.5 For instance, both consultants knew that the financial institution providing the financing for the client usually took four to six weeks longer than other banking institutions which increased the chance of slow payment substantially. The logical inference should have been that the slow payment was inevitable. The uncertainty was valid and the risk increased based on this prior information alone. By adding a quantifiable measurement, both consultants would have been drawn to a different conclusion and the outcome of very slow payment would have been expected.

Chance can be viewed as a process “in which a deviation in one direction induces a deviation in the opposite direction to restore equilibrium. In fact, deviations are not corrected as a chance process unfolds, they are merely diluted.”6 Nor are misconceptions about chance strictly limited to naïve subjects – people with training in statistics often make simple errors too.

At this point, it is necessary to determine whether the consultant’s decision-making methodology is required to include the need for absolute risk reduction or relative risk reduction. Absolute risk reduction can be defined as a measure of payment terms on which the client had actually paid for services rendered on time. Relative risk reduction should be defined as the number of times the consultants had been eventually paid regardless of the terms set. By viewing these in percentages, the consultants could quantify the risk being taken by extending terms to the client. This can be done by reviewing the frequencies associated with the situation. Frequencies can be defined as any number of observations in a particular class of events. Payments by clients could be considered a frequency. A frequency tree could be developed that helps understand the situation in a numerical way. For instance, if the consultants know the total number of clients that are currently in their individual practices, then a numerical frequency could be reached. Let’s say that each consultant had five-hundred (500) clients for a combined total of one-thousand (1000) clients. From previous payment histories, all clients had paid except one. By developing a frequency tree, the consultants could develop a good guess as to the chance of payment from an account based on prior payment frequencies.

Though the actual histories record a much higher percentage of clients that did in fact pay, the consultants still have to look at the chance that a client will not pay, in this case, it would be one in two or fifty (50) percent.

When does uncertainty qualify as a risk? For the answer it is possible to look toward cumulative prospect theory which “applies to uncertain as well as risky prospects with any number of outcomes, and it allows weighing functions for gains and losses”.7 Risk aversion is generally assumed for purpose of economic analysis of decisions under uncertainty. Risk-seeking choices can be generally observed in two classes of decision problems.

“First, people often prefer a small probability of winning a large prize over the expected value of that prospect. Second, risk seeking is prevalent when people must choose between sure loss and a substantial probability of a larger one.”8

Recently a client contracted for a seminar to be provided for an international sales meeting in Toronto, Canada. In the presentation of the proposal to the president of the company, the Vice-President of Human Resources overlooked the workbook material fees outlined which were in addition to the seminar fee. This resulted in internal confusion and budget items that were not included for the meeting. The consultant was faced with losing a large portion of the fee or being paid simply for the work materials which had already shipped to arrive in time for the meeting. The consultant chose to assume a sure loss rather than a complete cancellation of the seminar and the return of material already shipped. When the president refused to pay the total investment that was originally proposed, the consultant was initially risk adverse, but made the decision to reduce the price based on risk seeking realizing all of the preparatory work had already been completed. Considering some payment for the job better than none since substantial work had already gone into completion of the materials, the consultant was an example of the second class choosing between a sure loss and a substantial probability of a larger one.An event has greater impact when it turns impossibility into a possibility, or possibility into certainty, than when it merely makes possibility more or less likely.9 The decision when faced with uncertainty calls for the evaluation of two attributes, does the decision-maker desire a particular outcome or outcomes and what is the likelihood that the desired outcome will occur. The process of decision-making is concerned with assessment of these values and the manner in which they are combined to make the decision as well as the assessment of the circumstances under which the decision will be made.10

Events can be further sub-divided into functions or capacities, or in theory non-additive probabilities. Further dissection of a non-additive probability requires that two conditions are probable: lower subadditivity or upper subadditivity. Lower subadditivity provides that the impact of an event A is greater when it is added to a null event than when it is added to some nonnull event B. Upper subadditivity provides that the impact of an event A is greater when subtracted from a certain event C than when subtracted from some uncertain event A or B.11

For example, if the consultant had an additional seminar opportunity (event B) interjected into the decision making which would have occurred at a concurrent or approximate time as the seminar in Toronto, the lower subadditivity would have been considered in the process of making the decision. Likewise, if a secured program (event C) had been signed and paid for by another company, the consultant would have considered the upper subadditivity in the decision being made because the event would have been certain. The decision to tell the client in event A would have been to find someone else to do the seminar. The decision would have been weighed on more than financial considerations, including the client’s integrity and poor negotiation skills. It is subadditivity that emerges as an underlying principle of decision-making that is manifested to varying degrees in decisions when risk or uncertainty is present.

Are internal circumstances or issues more important than external events? Though situations vary from circumstance to circumstance, the internal issues are weighed more heavily than the external because the decision immediately impacts the individual making the decision. External events generally happen with circumstance beyond individual control which provides uncertainty. Internal events, on the other hand, are more often a direct result of prior decisions that have been made based on the criteria stated in prior paragraphs associated with risk.

There are certain activities that can be attributed to this type of decision internalization which should be mentioned. Given that most decisions are difficult to rationalize, they, in fact, become an anomaly and sometimes difficult to explain through normal biases that individuals have internalized. There are three such situations that should be mentioned. These anomalies include the endowment effect, loss aversion, and the status quo bias.12

The endowment effect is a pattern that people often demand much more than they are willing to give up. This pattern is often seen when individuals have the opportunity to sell a business they have started from the beginning, but want a price for it that includes so much good will that the company is actually not sellable. This effect pushes individuals to rationalize that the worth of the company is greater because of their individual involvement rather than the actual dollar value of the assets being acquired.

The status quo bias can be viewed as the need to keep the situation exactly the same because of a fear of possible loss or change which would make the individual uncomfortable with the associated risk. This can be viewed often when a particular stock investment is purchased at a high price. The stock declines and the broker recommends that the stock be sold at a current lower price to cut the investment loss. The individual does not sell the stock hoping that the price will again return to the higher price at which the stock was originally purchased. The status quo bias is in and of itself a decision by effectively not making a decision. This same individual may also view this as loss aversion in that it will make things worse to sell the stock. The fact that the changes may make things worse looms larger than potential improvements or gains.13

Most often these effects are associated with external events.

“It is the nature of economic anomalies that they violate standard theory. The next question is what to do about it. In many cases there is no obvious way to amend the theory to fit the facts, either because too little is known, or because the changes would greatly increase the complexity of the theory and reduce its productive yield.”14

When examining efforts by the individual to make informed decisions based on both internal and external factors, external anomalies can also be considered internal decision factors. This increases the importance of the individual biases over the external events that have occurred.

What will minimize the uncertainly to make the risk quantifiable for accurate assessment? The ability of managers to make decisions does have a great deal to do with both training and hindsight. The ability to have gained knowledge from prior decisions made or situations incurred provides a good check to see if prevailing conditions are right for a similar or like response once the decision has been made. Although the past never repeats itself in complete detail, it does have certain repetitive elements that provide insight into the experience.

“People make the same kinds of decisions, face the same kinds of challenges, and suffer the same kinds of misfortune often enough for behavioral scientists to believe that they can detect recurrent patterns. Such faith prompts psychometricians to study the diagnostic secrets of ace clinicians, clinicians to look for correlates of aberrant behavior, brokers to hunt for harbingers of price increases, and dictators to ponder revolutionary situations.”15

For purposes of this paper, this can be referred to as hindsight. However, hindsight cannot be used as the sole variable in making a decision. Some additional clues as to the facts surrounding the decision may provide substantive reasons for making a decision one way or another. For instance returning to the prior example of the consultants faced with the decision of extension of credit terms, the simple voice inflection of the client when speaking with the consultants could have been a factor in making the decision. It would be difficult to provide a formal model for the decision process though many have tried. Handicapping horse races is a good example of this. The handicapper may have good information about all the variables, but the variables may not be totally accurate based on particular circumstances surrounding a race. This was also true with the consultants. They were familiar with most of the variables, but not privy to the thought process of the client who was dependent on a second home mortgage to secure prompt payment.

“A simple substantive theory indicating what variables people care about when making decisions may be all one needs to make pretty good predictions of their behavior. If some signs encourage diagnosis or decision and others discourage it, simply counting the number of encouraging and discouraging signs will provide a pretty good guess at the individual’s behavior.”16

The temptation to embrace complicated theories without taking account of the insight that simple underlying notions provide may not be the best course of action.

Managers also tend to focus on the failure of past decisions or past managers who have found themselves in a similar situation to provide insight into the problem. Though this may not be the best course of action, it seems to be the most prevalent. Aphorisms such as “learn from the past” or “you can’t learn without making mistakes” are common business vernacular which point to this. They also point to an unbalanced appraisal of prior performance by those in charge at the time. Managers need to assess the situation to make a better decision than those that were made in the past lest the past will likely repeat itself.

Can managers be taught to correctly decide how much risk is acceptable when uncertainty is present? There are certain limitations that all managers face when making a decision that underscores risk and uncertainly. One limitation is the ability of the manager to analyze the problem without the benefit of cumulative, statistical experience. A second limitation is that misconceptions are often widely shared within management teams within an organization. Prior decisions are made on advice shared from others within the group that have or have had similar issues to address.

“If we know what has happened and what problem an individual was trying to solve, we should be in a position to exploit the wisdom of our own hindsight in explaining and evaluating his or her behavior. Upon closer examination, however, the advantages of knowing how things turned out may be oversold (Fischhoff, 1975). In hindsight, people consistently exaggerate what could have been anticipated in foresight. They not only tend to view what has happened as having been inevitable but also view it as ‘relatively inevitable’ before it happened. People believe that others should have been able to anticipate events much better than was actually the case. They even misremember their own predictions so as to exaggerate in hindsight what they knew in foresight (Fischhoff and Beyth, 1975).”17

How great is the influence of the past in making present day decisions? Perspective is a key driver in making decisions. To have perspective, it may not be necessary to draw on past experiences. As discussed earlier, basic facts and quantifiable probabilities should be enough to provide enough information for a good guess as to the probable outcome of the decision. However, due to the humanness of managers running organizations, the past is always brought into the decision-making process either by others who have had faulty experience or by the individual themselves. Four areas should be mentioned when considering decisions made from general lessons of the past.

1. Present day biases. Every manager is captive to their own personal perspective and knows things that those living in the past may not have known. This results in the ability to have insight into personality traits modeled with current day situations and completed past experiences that form personal biases which influence the decision at hand.

2. Method for determination. Managers often form blinders that restrict their own perspective because they adhere to only a single methodology or scientific method. No single method is adequate for answering many of the questions that have already been answered thanks to a past situation. Though each provides some insight, it can also mislead to some extent. Thus, a broad range of techniques should be part of every manager’s skill set.

3. Continual Learning. If the past is to be a subset of specific criteria to be drawn upon when decisions are made, it cannot be treated in isolation. The rules used to explain past decisions must also be the rules that are used to make current and future decisions. By keeping good records or notes, the relevant experiences will not be lost. By cataloguing processes from the beginning, the process is kept for future consideration, analysis, and evaluation. In addition, the manager gains validation and confidence in the decision-making process that has been selected.

4. Managerial Indeterminism. Managers are not entirely governed by external conditions. They have to retain a certain freedom and spontaneity as a result of freedom of will. Some decisions may not have a right or wrong answer due to poorly formed questions, situations, or issues. There may not be a good process or statistical answer that provides insight into the answer because there is, in fact, no correct answer or solution.18 What prepares managers for this type of decision-making? Formal training is only one aspect of the job description. Managers are indeed victims of their own environment in that they make decisions based on prior knowledge of situations encountered by managers in their position previously. The uncertainty of the correct decision is qualified by factors of circumstance that are weighed in either positively or negatively. Quantifying risk provides numerical data for weighing the decision. However, other factors must play a role in the final decision.

Accurately weigh the importance of historical evidence. The manager can learn from history, but the facts must be analyzed in way to provide non-weighted input. This is due to the individual spin that each manager will interject once the historical evidence is presented. Conditions that surround the internal circumstances may be different as are the conditions that surround the external circumstances. Without a full understanding of as many of the issues as can be reasonably presented, the evidence that is used to make the decision by the manager is somewhat limited to hindsight, theirs or someone else’s.

Understanding of the circumstances. Fact gathering is an area that needs particular emphasis. The facts have to be as reliable as possible although it is sometimes impossible to have all the component facts assembled in a fashion that provides complete understanding of the situation or issue. The circumstances surrounding a decision may have certain similarities to other situations that have or are being encountered, yet each component part must be weighed on its own merit. The manager must be diligent in the evaluation and as thorough as possible to ascertain specific pros and cons of the decision that is to be made.

Learned heuristics and bias awareness. Managers bring with them specific areas of bias that have been acquired over time, perhaps as far back as childhood. Decisions involve individual values and heuristics that are interjected by the manager, sometimes knowingly and at other times, not. Heuristic and bias awareness is a learned skill that should be employed by every manager when decisions are being made. When understanding the critical parts of why a judgment is being made and what its importance is to the situation at hand, the manager will make a more informed decision, although maybe not a better decision.

Risk perception. Managers encounter a certain amount of risk with every decision made. Being able to quantify the risk assessment provides a valuable tool for the manager to use. Being human beings first and managers second, the amount of risk that they are willing to accept will vary with the individual. The behavioral characteristics of the manager’s personality will provide insight into the acceptance or non-acceptance of risk as well as the amount that they are willing to take when a decision is to be made.

Methodology training. Understanding the probabilities and the frequencies within the decision criteria will allow the manager to make, given the above stated criteria are performed, an informed decision. The methodology should include a method in which the manager can quantify the decision criteria and also qualify through verification the decision criteria. Both areas are important, though many times both are not used by individual managers or managerial teams. A selection of criteria should be developed that will formalize the decision process that includes problem stating, analysis of situational criteria, risk calculation, historical precedent, and heuristic and bias awareness.

Finally, can a habit of correct circumstance assessment be developed to minimize risky decisions within the complete business environment? Based on facts stated above, the answer is yes. It is a habit which should be formed and cultivated that includes specific methodology to understand all component parts of the decision. Casual observation suggests that managerial judgment is generally good enough to let them make it through the course of normal business without getting into too much trouble. Obviously, there are exceptions which have negative consequences such as poor fiscal policy which impacts cash flow or can result in business bankruptcy. However, many businesses get by with mediocre decision-making processes.

When problems arise, it is easy to look for a culprit. It may entail a faulty or misunderstood task or it may be the faulty abilities of the manager. It could also be a poor selection of the individual manager responsible for a task that he is not well suited to. This occurs regularly in business when good people are mismatched with job requirements.19

The effect of debiasing individual managers as a corrective procedure can be considered when making the following observations:

  1. The underlying processes about which inferences are required are probabilistic.
  2. Problems arise in the integration rather than the discovery of evidence.
  3. The biases are considered non-substantive.
  4. Some normative theory is available characterizing appropriate judgment.
  5. No other obvious inducements for poor behavior are apparent.20
Though no clear cut means is available to every manager for every situation, certain areas of focus can increase the potential that a good habit formed will produce favorable results and minimize risk. Some managers will have particular advantages while others may be at a disadvantage depending on how they got to their position and their personal awareness of their own judgmental limitations.

For every manager, it is easy to see a way in which some will have an advantage while others will not. These steps should be considered.

  1. Abundant practice with a set of homogeneous tasks. Managers should have such experience. They use it to hone their judgmental skills or they may develop situation-specific habitual solutions, freeing themselves from a need to analyze and think.
  2. Clear-cut criteria in the event at hand. Although managers are often required to make explicit decisions, the objects of the decision are often components of themselves complex and integrated systems thus making it hard to evaluate the manager’s level of understanding. “Off target judgments may be due to unanticipated contingencies, whereas on-target judgments may have been right for the wrong reasons.”21
  3. Task-specific reinforcement. Managers are paid for performance. However, even when good judgment lapses into poor judgment, they still receive remuneration for the judgments made.
  4. An admitted need for continual learning. At every stage of the process of professional managerial development, certain advantages accrue to those that accept a need for continual self-development. This admission produces advantages for those that do a good job and subsequently critical managerial competencies increase.22

Situational circumstance is a key factor in assessing uncertainty and risk by the decision-maker. Calculated risk provides insight for good managerial protocol. Probabilistic issues arise in the course of normal business which can be analyzed by manager with developed skill sets which minimize uncertainty and risk. But no matter how involved the process or methodology put forth, the basic aspects of human nature plays as big, or even a bigger part in the final decision that the manager makes.

An error in judgment can be demonstrated through accepted rules of arithmetic, logic, or statistics. Not every decision made that appears to contradict an established fact or an accepted rule is considered a judgmental error. It may be as simple as the manager’s misunderstanding of the question or the manager’s misinterpretation of the answer. The use of heuristics and biases when applied to the decision-making methodology can provide the manager with a measured approach. The use of heuristics does not preclude the use of other procedures that can be used of evaluate situations as have been stated above. However, the evaluation process is more complete when heuristics are applied.

NOTES:
1Calculated Risks, by Gerd Gigerenzer, published by Simon & Schuster, New York, NY, 2002, page 257.
2Ibid.. page 256.
3Judgment Under Uncertainty: Heuristics and Biases, edited by Daniel Kahneman, Paul Slovic, and Amos Tversky, published by Cambridge University Press, 1982, pages 163-179.
4Ibid., Judgement Under Uncertainty: Heuristics and Biases, pages 48-51.
5Ibid., Calculated Risks, page 248.
6Ibid., Judgment Under Uncertainty: Heuristics and Biases, page 7.
7Choices, Values and Frames, edited by Daniel Kahneman and Amos Tversky, published by The Press Syndicate of the University of Cambridge, Cambridge, United Kingdom, 2000, Chapter 3, page 44.
8Ibid., Choices, Values, and Frames, pages 45-46.
9Ibid., Choices, Values, and Frames, pages 93-96.
10Ibid., Choices, Values, and Frames, page 96.
11Ibid., Choices, Values, and Frames, pages 97-101.
12Ibid., Choices, Values, and Frames, pages 159-170.
13Ibid., Choices, Values, and Frames, pages 159-165.
14Ibid., Choices. Values. And Frames, page 165.
15Ibid., Judgment Under Uncertainty: Heuristics and Biases, page 336.
16Ibid., Judgment Under Uncertainty: Heuristics and Biases, page 338.
17Ibid., Judgment Under Uncertainty: Heuristics and Biases, page 341.
18Ibid., Judgment Under Uncertainty: Heuristics and Biases, pages 349–351.
19Ibid., Judgment Under Uncertainty; Heuristics and Biases, pages 422-440.
20Ibid., Judgment Under Uncertainty: Heuristics and Biases, page 442.
21Ibid., Judgment Under Uncertainty: Heuristics and Biases, page 443.
22Ibid., Judgment Under Uncertainty: Heuristics and Biases, page 444.



RESOURCES:

Judgment Under Uncertainty: Heuristics and Biases, edited by Daniel Kahneman, Paul Slovic, Amos Tversky, published by Cambridge University Press, Cambridge, U.K., 1982.

Choices, Values, and Frames, edited by Daniel Kahneman and Amos Tversky, published by Cambridge University Press, Cambridge, U.K., 2000.

Calculated Risks: How to Know When Number Deceive You, by Gerd Gigerenzer, published by Simon & Schuster, New York, NY, 2002

Heuristics and Biases: The Psychology of Intuitive Judgment, edited by Thomas Gilovich, Dale Griffin, Daniel Kahneman, published by Cambridge University Press, Cambridge, U.K., 2002.





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