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Behavioral finance FAQ / Glossary (Decision)

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Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

Decision, decision-making



06/4i - 08/10i,12i + see cognition,
emotion, rational, neuroscience,
model, delaying tactic, heuristic,
utility

Rational neurons and emotional neurons boxing
for championship
in the ring of uncertainty.

Definition

Decision-making is choosing between
several possible courses of actions
related to an issue.

OK, this is reductive (what about digging first to find what are the
options?
).

It is also a platitude, as of course a decision implies a choice. But a far-reaching
and daunting one, as it is often hard to make choices.

Shakespeare has shown in "Hamlet" how agonizing it can be.

Also, Buridan described how a fictional donkey died from delaying tactic
(see that word) when having to choose what to absorb first, its water bucket
or its bale of hay.

Cognition and emotion (see those words)
      
are the two breasts that feed decision.

The trick is to use the right dose of each milk.

Reflexes and their cousins (see automaticity,
habit, heuristic....) also play a part but can a
reflex be called a decision ?

Decide with your head, your heart, your guts, your feet.
Or just ask your spouse!

The process, step by step

Ideally, an elaborate artwork

The decision-making process - and its cousin the problem-solving process -
are often filled with complications and pitfalls.

Normally, at least for tricky decisions in complex situations and when
there is time available (OK, a lot of "if"), the process includes several
steps
:

Identification
steps

 

 



1) Perceiving an issue, a situation that could entail 
   
decision-making,

2) Gathering information,

3) Recalling knowledge and prior experiences,

4) Understanding the various sides of the issue and
    doing a diagnostic,

5) Imagining the possibilities of actions,

Evaluation
steps




6) Comparing and evaluating those
    possibilities

Here, various preferences (see that word),
goals and values
intervene.

Also various methods and criteria are needed.

To take just an example, the personal degree 
of risk attitude plays a part.


 Action
 steps



7) Making the choice (including a planning
    when needed)

7b) and ...implementing it.
      If not it is not a decision!

And it can be in the implementation that either
nothing happens, or everything falls to pieces.
Adjusment
is the word !

pi-arrig.gif A rerun might also be helpful

Play it again, Sam!

Of course, such an ideal process needs a lot of means, efforts or time,
all the more if the goal is to optimize the outcome to the last penny.

Also some iteration is useful, in other words "think
twice"
.

Some studies have shown that our most accurate
evaluation
is often the average between two evaluations
we made at rather distant moments.

It is as if the thinking process evolves with the time devoted to it, by
taking into account other elements of understanding that were
overlooked at first
.

Always remind to keep cool, and whenever possible to
"sleep over it"
(of course only after having analyzed things
seriously while awake).

This allows our neuronal connections to make their little dance
to clarify things and the right chemicals to be secreted into the
brain, so as to cool off after the first impression or emotional
reaction.

The several step process shown above should not mean indecision or
procrastination
(see delaying tactic, status quo bias...), all the more in an
emergency when we have to react fast.

On the other hand, having thought before at several scenario might precisely
help to see clear in an emergency.

The pitfalls ...or shortcuts

Missing the step and falling?
Or finding an elevator and rising?

Most behavioral biases (see that phrase), bringing suboptimal or harmful
outcomes, originate from flaws at the decision making steps.

Here are some mental phenomena involved in decision making
that might might be dangerous distortion ...or wise shortcuts

An (opportune or not) bias for action and risk
   taking
might abridge some, or all, of the above steps.

Some "fast track" decisions (heuristic) or even
  instantaneous, unconscious,
automatic (see
 "automaticity bias").

Here the process is bypassed because of either:

A (real or supposed) emergency (a sudden danger ...or instant
    opportunity
not to miss

The need not to lose time on a secondary issue for which a
    routine heuristic
(see that word) can do the job. 

An automaticity, knee jerk reflex, habit (see those words).

Those are pure reactions more than real decisions.

An "intuition" (or "instinct"), fed by

  
On the rational side

.. experience, hard training, clear idea of what we
   pursue,

...sudden imaginative insight after a long analysis
   of the issue, when a mental opening sbows how
  
to put all  the pieces together. It should not be
   confused with an emotional impulse or lazy
   thinking as seen below


On the irrational side.

...uncontrolled feeling (attraction, aversion)

...or mind conditioning

...or simplified superficial, lazy reasoning (see
   heuristic
)

Many of our decisions, whether conscious or
not, and many of our thoughts, have been
influenced by a silent crossing and assembling
of complex data made
by our neurons "in the
background

As seen above, an antistress method, and also
waiting overnight to decide or apply a decision
can help muster this unconscious power.

Well, intuitions might give brilliant adaptive
solutions (or spot useful warning signals, but
they need to be (intuitively ??) screened from
illusions or compulsions
.


And overall an aversion to decision because of a reluctance
    to
the effort of digging further and the pain to have to
    make
a choice. 

The opposite bias is over-reflection, with the risk of

falling into inertia (see delaying tactic, status
quo bias..).

If we made a formal analysis anytime we move a finger, we would
spend all our time
in thinking instead of doing things, and would die
from inaction.

Some balance has to be found between:

Spending too much effort for a trite decision just because

of an extreme risk aversion / action aversion / decision
aversion / underconfidence

Even some crucial and risky decisions have to be taken 
with the guts, if not they are never taken

And failing to prepare enough for a decision that might be

vital, and that requires to reassess the situation.

A common aspect is that people tend to accept the default solution.
That is why pension plans are operated this way, a decision effort is
needed to opt against them.


Decision making is a complex human process
   involving
cognition, rationality, imagination and emotion

(see those words).

Every decider has its own style that reflects the relative importance it
gives usually
to each of those factors when he makes choices.

Many cognitive and emotional biases might bypass objective
    
observations  and clear decision criteria, and make the process
     derail 
in several of its sides and steps.

An important source of biases is, as seen below
(neurosciences), a primacy
of emotions (see emotion)
over logical thinking.

On the other hand, it is understandable in some degree,
as few actions would be taken if deciders were pure
emotionless spirits.


Risk and uncertainty do not make things easier.

It is the case in economic and finance related decision, which

are bets on complex and foggy
prospects.

Actually, the challenge is the same in most other life circumstances.

What happens in the brain?

Which neurons - and brain secretions - will win the battle?


Neurosciences
(see that word) are now contributing to study what is at play
when human beings make decisions.

This field of research examines chiefly, luckily without opening people's
skulls,

What brain areas (and chemical secretions) play a part in the
    process

What stimuli are influencing those areas or secretions

And also what other areas of the brain oppose resistance to th
    same stimuli.

Yes, there are some "moderator" neurons (and secretions), a
kind of inside brain police, a simplification of course for something
much more complex.


In many circumstances emotions, and the
pains / pleasures that are behind, override logic
in
decision making.

Emotions are what motivates people to act.

With only thoughts, and without emotions, people would spurn actions
except some near automatic routine maintenance.

Decision making in economics and finance

Nothing like money
into the human thinking machine slot
to activate its gears.

Among all human activities in which decision-making is crucial, those related
to money make a large subset.

A typical example is investing in asset markets.

To buy or sell a financial asset belongs

to "decision under risk and uncertainty".

=> This is how this kind of choices have been qualified:

By probability theorists

(probabilities and stochastic calculation, see those words, are the basic
food of most standard financial decision models),

As well as by behavioral finance theorists, such as Daniel Kahneman,

who distance themselves from those idealistic rational models.

When facing risk and uncertainty (see those words) people are
highly prone
to cognitive and emotional biases that lead to
decision errors (*)
.

Their decisions might not match exactly their " utility" (**),

although that concept is one of the bases of economic theory

(*) This glossary cites many of those biases and errors.

In extreme cases, money can make people crazy.

Well, not only money can do it, but we are not here to talk about
all human fantasies.

(**) see "utility" in this glossary, and if you are interested on theoretical

       aspects, at the utility paradoxes contribution
   

Are computers better at
     financial decision making?

Robots playing with money.

It might work for a time.

But when to unplug them and take control?

And when to send them to the scrap yard?

Those human limitations have led to use computer models (see models)
to replace - or at least assist - human decisions in many fields, among them
economics and finance.

They are quite good at finding correlations and aplying probabilities.

It does not mean than computer-aided decision software
would always perform better except

* in some clearly defined recurrent cases
* and when the overall situation does not drastically change

The models currently in use are progressing, and "big data"

helps, but they still cannot encompass all factors, and even
less ...some highly scarce or unforeseeable events.

It might be good to disconnect the autopilot and use the manual
mode
when entering unexplored territory where rules
might bedifferent than those implanted into the electronic brain.

Here are a few examples of their limitations:

Computer models can lose relevancy in cases of "rare

events" (see that phrase) or new situations.

They are not too good at explaining new things and imagine new solutions.

If they are only trained to swim,
how can they behave if the lake dries up?

They have therefore a tendency to become obsolete, a "best before"
date would be useful in order to scrape them or to worry about an
upgrade.

VaR / Value at Risk, a model that aims at measuring and limiting risks in
  
financial institution, uses:

1) Quantified objectives and parameters that actually might be subjective,

2) Past statistics that might be unreliable ("garbage in, garbage out") or

not relevant to new situations: see numeracy bias.

pi-arrig.gif Economic prediction models should be taken with precaution (see for 

example the "numeracy bias" and  "range aversion"
bias).

System trading (see that phrase), based on mathematical models that

try to take advantage of market anomalies can be "taken by surprise"
when the whole
state of affairs obey new rules.

Also such automatons tend to create their own market anomalies by aping
one another in a kind of "computer herding".

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

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This page last update: 08/08/15  

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