Foundations of Decision Making

Decision making concepts

Making smart wealth management decisions

Along the path from where you are now to where you want to be, there are many decisions to be made. Some are fairly trivial and of little consequence. Others, however, poorly made, may significantly affect how your life turns out.

Our approach to wealth management is based on the premise that you will maximise the chances of things turning out as you would like by always making “smart decisions”. These are decisions that are based on processes and principles that both science and practice have shown are considerably more likely to result in desired outcomes. They contrast with decisions made both poorly and inconsistently – relying on “gut feel”, misinformation, what other people are saying or doing etc.

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Smart decision making does not come naturally. The behavioural scientists have shown that we exhibit many psychological biases that may inhibit effective decision making. Left to our own devices we are not the rational informed decision makers assumed in economics but often exhibit irrational behaviours inconsistent with our best interests.

In “Foundations of Behavioural Science” we discuss a number of those psychological biases and their potentially damaging consequences for your wealth management objectives. In the area of investment, a disciplined adherence to the strategies that emerge from the research of the world’s leading financial economists (as described in “Foundations of Financial Economics”) will help you to avoid those biases. But there are many other areas of your life that can be potentially enhanced by understanding and applying a few key decision making principles.

What is a good decision?

A first step in effective decision making is to understand what a good decision is or isn’t. Most people consider that a good decision is one that has a desirable outcome. The learning then is that if a particular approach to decision making had a good outcome last time, it will work next time.

However, once a decision is made, there are any number of factors unrelated to the decision making process that can affect the outcome. There is a real danger of confusing cause and effect.

This happens often, too often, in business and finance. A couple of outstanding successes lead to the conclusion that a business person or investor is skillful, rather than simply lucky or an unwittingly excessive risk taker. This may lead to hubris and overconfidence, bigger bets, and often spectacular failure when the true soundness of the decision making process is revealed (e.g. in 2008, witness Allco, Babcock & Brown, Centro, ABC Learning, MFS, General Property Trust etc. etc.).

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In their book “Making Great Decisions in Business and Life” David Henderson and Charles Hooper describe a good decision as:

“… one that you would choose to make again and again, even though you occasionally get stuck with a bad outcome.”

In a similar vein, John Hammond, Ralph Keeney and Howard Raiffa in “Smart Choices” note that:

“… a good decision doesn’t necessarily guarantee a good result, just as a bad decision doesn’t necessarily guarantee a bad result. The careless can hit it lucky; the careful can be shot down. But a good decision does increase the odds of success and at the same time satisfies our very human desire to control the forces that affect our lives”.

Making “smart financial decisions” is not about always having a great outcome – this is an unachievable standard to set. Rather, it is about using robust processes and relevant research to bias the odds of desirable outcomes in your favour. In particular, smart financial decisions:

  • avoid known pitfalls in human behaviour and decision making;
  • focus on those things that can be influenced or controlled rather than those that can’t; and
  • where risk or uncertainty is involved, provide strategies with the best chance of achieving the desired outcome.

Below, we outline the elements of a sound decision making process. We then describe a number of key decision making principles that help make better wealth management decisions.

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