A Decision Making ‘Swiss Army Knife’

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May 10, 2022 ~ Written by: W.B. “Bud” Kirchner

Approx. Read Time: 12 Minutes

“Thinking is the hardest work there is, which is probably why so few engage in it.” – Henry Ford

A Decision Making Swiss Army Knife

As an (at least symbolic) statement we have advanced in the war on COVID-19 to the point that we can start to address items other than coping strategies. In these articles, I want to touch on a topic stimulated by feedback from Adrian Garcia who is the highly regarded lead instructor and architect of our Kirchner Investment Academy. Adrian reports that the largest stumbling block for new investor ‘students’ relates to land mines around decision making.

This certainly was not surprising to me given the complexity of making decisions with limited information. However, I thought perhaps there was a ‘Swiss army knife” that would help from many perspectives. For example, a tool that is:

  • Easily understood (in the form if not function)
  • Flexible
  • Practical
  • Universally applicable

Background

“It is the marks of an educated mind to be able to entertain a thought without accepting it.” – Aristotle

Needless to say, a topic as broad and salient as decision making has received a fair amount of attention in past articles on this platform:

The Designated Winner

“Sixty minutes of thinking of any kind is bound to lead to confusion and unhappiness.” – James Thurber

As I reviewed the above extensive list from the archives, I thought what if I could only share one paradigm – one that has both broad and specific (that is to say practical) applications – one that embraces several other concepts within the realm of risk and uncertainty.

Let me set the stage by saying my evaluation is not unique. The paper by Kahneman and Tversky, titled Prospect Theory: An Analysis of Decision Under Risk, is the most cited paper to appear in the academic (my emphasis) journal Econemerica. In other words, this is heavy (mathematical) stuff.  So, here’s a concise (usable) summary for we businesspeople (#5):

  • Loss aversion
    • We give perceived gains more weight than perceived losses
      • Also identified by the moniker “loss aversion theory”
    • We are reluctant to abandon initiatives
  • Relative positioning
    • We are most interested in relative gains and losses rather than final worth
    • We become biased toward things we are familiar with
    • We pass on proceeds if we don’t feel we receive our fair share
  • Conservatism
    • We accept exposure to what we think are low-probability events
    • We prefer certainty and are willing to sacrifice gains to achieve more certainty
    • We often act naive

A ‘Swiss army knife’ prospect theory may not be the perfect solution in a situation, but it can provide “stop-gap” assistance as it highlights the tradeoff between values often leading to additional specialized “tools”.

A Walk Down Memory Lane

“We can be blind to the obvious, and we are also blind to our blindness.” – Daniel Kahneman

I have (no surprise I hope) written previously on this paradigm:

I have previously (and again now) highlighted:

  • “Behavioral and neuroscience work on the prospect theory and the neuroscience of behavioral decision-making.” (#4)
  • “Prospect theory allows for the fact that individuals may choose a decision which doesn’t necessarily maximize utility because they place other considerations above utility.” (#6)
  • “The way economic agent subjectively frames an outcome or transaction in their mind affects the utility.” (#8)
  • “Prospect theory differs from standard economic models that always encourage prudence as the better part of valour.” (#3)

Additional (complementary) Perspective

“A mind stretched by new ideas never goes back to its original dimension.” – Oliver Wendell Holmes

A particularly succinct overview of this theory is found in the writing of Morris Altman (#1) and is quoted in the following:

“Prospect Theory, a theory about how people make choices between different options or prospects, is designed to better describe, explain, and predict the choices that the typical person makes, especially in a world of uncertainty”.

Prospect theory is characterized by the following:

Certainty: People have a strong preference for certainty and are willing to sacrifice income to achieve more certainty. For example, if option A is a guaranteed win of $1,000, and option B is an 80 percent chance of winning $1,400 but a 20 percent chance of winning nothing, people tend to prefer option A.

Loss aversion: People tend to give losses more weight than gains — they’re loss averse. So, if you gain $100 and lose $80, it may be considered a net loss in terms of satisfaction, even though you came out $20 ahead, because you’ll tend to focus on how much you lost, not on how much you gained.

Relative positioning: People tend to be most interested in their relative gains and losses as opposed to their final income and wealth. If your relative position doesn’t improve, you won’t feel any better off, even if your income increases dramatically. In other words, if you get a 10 percent raise and your neighbor gets a 10 percent raise, you won’t feel better off. But if you get a 10 percent raise and your neighbor doesn’t get a raise at all, you’ll feel rich.

Small probabilities: People tend to under-react to low-probability events. So, you may completely discount the probability of losing all your wealth if the probability is very small. This tendency can result in people making super-risky choices.” (#1)

Context

“Stay committed to your decisions but stay flexible in your approach.” – Tony Robbins

As always, I defer to the experts for a salient summary:

  • “Subjects, when offered a choice formulated in one way, might display risk-aversion but when offered essentially the same choice formulated differently might display risk-seeking behavior.” (#7)
  • “Kahneman and Tversky found empirically that people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty; also, that people generally discard components that are shared by all prospects under consideration.” (#2)

Takeaway

Having shared a vast inventory and the pick of the crop to enhance decision making, the takeaway “alert” for astute decision-makers is while unfortunately there isn’t a magic bullet, you can leverage a ‘Swiss army knife approach.  It is however impossible to ensure that nothing will go wrong as articulated by sources as diverse as a Yiddish proverb and Alabama folklore.

Bibliography

  1. Morris Altman – What is Prospect Theory?
  2. Namoura Coffee – Prospect Theory
  3. Encyclopedia Britannica – Prospect Theory
  4. Craig R. Fox and Russell A Poldrack – Prospect Theory and the Brain
  5. Daniel Kahneman and Amos Tversky – Prospect Theory: An Analysis of Decision Under Risk
  6. Tejvan Pettiger – Prospect Theory
  7. San Jose State University – Kahneman and Tversky’s Prospect Theory
  8. Wikipedia – Prospect Theory

About the Author: W.B. “Bud” Kirchner is a serial entrepreneur and philanthropist with more than 50 years of business success. He is not a scientist or an academic but he does have a diversified exposure to neuroscience, psychology and related cognitive sciences. Generally speaking, the ideas he expresses here are business-angled expansions of other people’s ideas, so when possible, he will link to the original reference.