Behavioral Decision Making and Risk Management

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Behavioral Decision Making and Risk Management

• X.T. Wang
• Email xtwang_at_usd.edu

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Content and Topics

- Organizational Management under Uncertainty -
Value, Utility and Theories of Risky Choice -
Biases in Judgment and Decision Making - Bounded
Decision Rationality - Tri-Reference Points
Theory of Risky Decision - Risky Choice in
Management and Everyday Life - Risk Perception
and Happiness - Cultural Values and Management
- How to Reduce Biases and Make Smart Choices -
Case Analysis and Discussion
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Key Features of the Course

Simons Contributions - Management is
decision making - Bounded Rationality
(Cognitive limitations Structure of Task
Environment) Kahnemans Contributions -
Systematic biases in human judgment and decision
making. - Value functions and reference points
Perspectives of psychologists Common instead of
specific psychological mechanisms Empirical
approach Find blind spots and avoid decision traps
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Research and Applications

Accuracy
Experiments
Generality
Reality
Field Studies
Theories
Research Triangle
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Aims of the Course

Fish and Fishing Psychology of Management
Habits and Behaviors of Fish Presenting rocks
to get gems Teaching is learning
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Management and Risky Choice

What managers do Achieve an organizational goal
in a risky environment, by team work
Functions Roles Skills
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Define Risk with Personal Examples

Risk Risky Choice Common factors you consider
when making risky choice Examples
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Human Decision Making

• Risk is the essence of life, which keeps the mind
  busy perceiving, feeling, thinking and deciding.
• Risk demands choice, choice means freedom, and
  freedom has its cost.
• A life story can be viewed as a temporal sequence
  of risky choices.
• Management is decision making. Decisions
  determine success or failure.
• Diligence and hard work cannot warrant correct
  decisions(e.g., beginner of swimming)
• Understand the process and mechanisms of decision
  making under uncertainty

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A Model of Organizational Management
Structure
Vision Leadership
Environment Consumers Competitors Technology G
overnment Community
Strategy Key Assets Competence financial
material technological capital of
employees customers suppliers
Value Shareholders Customers Employees Supplie
rs Communities
Formal Structure
Control System
Culture
Informal Structure
Ecological Rationality
Economic Rationality
Social Rationality
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Business Environment and Cognitive Process of
Management
Feedback
Judgment Interpretation of Information
Uncertain External Environment
Perceived Reality
Execution
Decision
Quality of an Entrepreneur
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Dealing With Uncertainty

• Characteristics of Uncertain Business Environment
• Market Uncertainty
• System and Policy Uncertainty Risk
• Technical Uncertainty
• Management Uncertainty
• Reactions of Successful Business Leaders to
  Uncertainty

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Three Kinds of Decisions

• Decisions under certainty
• Decisions under uncertainty
• Decisions under risk

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Certainty, Uncertainty, Risk, and Fate
Fate Uncertainty Risk certainty

• Life Destiny (Determined) Luck (Variable)
  Effort (Controllable)
• Personality determines personal fate
• Modesty is not only an attitude towards life but
  also a judgment about uncertainty.

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• Three Research Approaches
•  
• Normative approach
• What the optimal choice or decision would be
•  
• Prescriptive approach
• What people should do
• Descriptive approach
• What people actually do
•  

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Assumptions of Decision Making Theories

• Expected utility maximization
• (Normative theory of risky choice)
• 2. Risk (variance) minimization
• (Economic and finance models of risky choice)
• 3. Reference point-dependent value functions
• (Psychological models of risky choice)

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Models of Risky Choice
The Idea of Mathematical Expectation Pascal's
Wager
____________________________________________ Po
ssible Outcomes Options God exists God
does not exist . Christian
life Otherwise ____________________
________________________  
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Expected Value Model Maximize Expected Value
n EV ? pi . vi i1 where pi is
the probability of outcome i, Vi is its objective
value, and n is the number of possible outcomes
in a prospect. Gamble A Coin flipping. If
heads, win 100 if tails, lose 80  Gamble B
Coin flipping. If heads, win 90 if tails,
lose 60   Which gamble has a higher EV?
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Daniel Bernoulli and the St. Petersburg
Paradox Suppose that a fair coin is tossed until
tails first appears, at which point the player is
paid a sum equal to 2n, where n is the number
heads outcomes (the number of the toss on which
tails appears). How much should a person be
willing to pay for a single play of the
game?   EV 1/2(2) 1/4(4) 1/8(8)
1/16(16) ... 1/2n(2n) 1 1 1 1
... 1 ... ?
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Bernoullis Solution of the Paradox Bernoulli
disputed the idea of value objectivity by
assuming that the utility of wealth is
logarithmic function of the monetary value.
n EU ? pi . Log2(vi) i1     EU
1/2log2 (2)1/4log2 (4)1/8log2 (8)
...1/2nlog2(2n) 1/2(1) 1/4(2)
1/8(3) ... 1/2n(2n) 1/2 2/4 3/8
... n/2n 2 4.  Bernoulli's theory
predicts risk aversion
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Expected Utility Theory

• Expected Utility Theory provides normative
  solutions for risk taking
• n
• EU ?piu(vi)
• i 1

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One Ship or Two? Decision Tree
Ships Sunk
Prob.
Value
Expected Utility
Utility (X.5)
safe
0
80
100m
8util
10
80
All gold in one ship
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1
20
0
0
0
sunk
8.0util
Ship 2
0
64
100m
6.4util
10
safe
80
Ship 1
20
safe
16
50m
1.1util
7.1
1
sunk
80
All gold in two ships
20
safe
sunk
1
16
50m
1.1util
7.1
80
20
sunk
2
4
0
0
0
8.6util
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Utility Measures and Analysis
Principle of diminishing marginal utility As
more units of a good are consumed, additional
units will provide less additional satisfaction
than previous units.
Illusions caused by diminishing marginal utility
The first candy is the best The last
piece of meal is the most satiating
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Utility Measures and Analysis Marginal Utility
Two Results of Diminishing Marginal Utility
Consumption Decreases Consumption Increases
Illusions of Marginal Utility It is the
last unit that makes me full. Why Coca Cola
Failed to Replace its Classic Formula?
Market research was conducted before the
customers diminishment of marginal return had
fully devolved.
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Economy of Rich and Poor
Economy of the Rich and Economy of the Poor
80 of purchasing power comes from 20 of
consumers How to maximize the benefit? Demand-Su
pply Law For the poor For the rich
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Economy of Rich and Poor
Economic Risk (1) The rich is too rich and (2)
the poor is too numerous.
Risk Management Reduce (1) Reduce
(2) Control both (1) and (2)
Case Banks for the poor
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Measuring Utility Difference Measurement
To measure you own utility. a. Pick a lower and
an upper limit on the range that you shall
consider, say 0 to 1 million. b. Cut
this interval in half subjectively. Seek an
amount of wealth (x), such that the subjective
difference between 0 and x is the same as the
subjective difference between x and 1 million.
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Measuring Utility Difference Measurement
c. Continue in this manner, dividing the utility
interval in half each time. d. Assigned a
utility of 0 to 0 and a utility of another
larger number, say, 8 to 1 million, and a
utility of 4 (halfway between 0 and 8) to x.
To use utilities in decision analysis, we need
only relative values.
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Measuring Utility Direct Scaling
Imagine there are three possible outcomes the
job you have been offered (B) the possible
better offer (A) with a probability of .6 and
the least attractive job you would have to take
if the better offer does not come through (C).
A gt B gt C A100 and C 0 Where is B on a 0 to
100 scale? Is B greater than 60?
To assess your expected utility, you might assign
a value of 100 to job A, and a value of 0 to job
C and ask yourself where job B falls on this
scale. If the value of job B is greater than 60,
the expected utility of accepting job B is higher
than that of waiting.
For Job A, EV .6 x 100 60
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Measuring Utility Multi-Attribute Utility Theory
(MAUT)

• Linear Model
• Yi bo b1u (xi1) b2u (xi2) bnu (xn)
• Yi overall impression of the option i
• u utility functions
• x attributes
• betas weights
• (David Pierson, 1998 Kahn Meyer, 1991)

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Measuring Utility 6 MAUT Steps
1). Listing dimensions for evaluation and
comparison. 2). Weighting each dimension. 3).
Listing alternative choices. 4). Ranking the
alternative choices along each of the dimensions
(higher ranking is better). 5). Multiplying the
ranking by the weighting for each alternative
choice and adding products across all the
dimensions. 6). Choosing the alternative choice
with the highest value.
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Measuring Utility MAUT Applications
Case 1 A. Expand present plant, B. Build a new
plant, or C. Subcontract out extra production to
other manufacturers? 1. Dimensions Cost Return
Pollution 2. Weighting 1.0
0.8 0.6 3. Alternatives Expand Build
Subcontract 4. Cost ranking 3
1 2 Return ranking
1 3 2 Pollution ranking
1 3 2 5.
Computing Util. 3.8.6 12.41.8
21.61.2 6. Choose 4.4
5.2 4.8
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Prospect Theory (Kahneman Tversky, 1979
Tversky Kahneman, 1992)
Traditional decision analysis of describing
outcomes of decisions in terms of total wealth is
psychologically unrealistic. People do not
normally think of relatively small outcomes in
terms of states of wealth but rather in terms of
gains and losses in reference to their status
quo. It is the changes in wealth (gains and
losses) rather than ultimate states of wealth
(total assets) serve as the effective carriers of
subjective value.
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Prospect Theory (Kahneman Tversky, 1979
Tversky Kahneman, 1992)
Utility Weighted Probability x Weighted
Expected Value for Gains and Losses
separately relative to a neutral reference
point (often the status quo)
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Value Function
????
Psychological Value
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Prospect Theory Implications

• How to make good news sound even better?
• Individuals value a series of small gains
  more than a single gain of the same summed
  amount.
• How to make bad news sound less bad?
• Individuals are less upset by one large
  loss than by an identical loss suffered in
  multiple smaller parts.

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Prospect Theory Value Function

• Practical Implications
• Dont give all the rewards to employees at once
  Dont give in on a number of issues at once when
  negotiating with another party.
• Credit cards pool many small losses (debts) into
  one larger loss.
• In order to maximize subjective value or
  pleasure, you should learn to enjoy little gains.
  You would not then avoid good deeds just because
  they are trivial.
• A common problem for gambles and addicts is that
  they pursue only high pleasures.

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Prospect Theory

• Different Slops of Value Curves in Gains and
  Losses
• Pleasure of Salary Raise lt Pain of Salary
  Reduction
• Pleasure of Promotion lt Pain of Demotion
• Psychology of Thrifty
• make Money from own pocket
• Ordinary PeopleSave 1 gt Gain 1
• Entrepreneurs Save 1 lt Gain 1
• The value of risk depends on whos at risk.

What is your value function?
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The Oregon Experience Develop a priority ranking
of medical conditions and treatments. Give a
priority scores to each of 1600 different medical
services based on the ratio of cost to benefits
conferred. But failed to pass
One mans death is a tragedy. One thousand mens
death is a statistic. - Joseph
Stalin Willingness to Pay for saving X human
lives If ethnic cleansing happens in an African
country, when do you think the united nations (or
US) should intervene with military force in terms
of estimated number of deaths?
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 Value and Choice Whom Will You Rescue?
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Price of Life
Two cutoff points Value per life 1 life worth
7 million (willingness to pay method)
Cost-ineffectiveness 21 million s (more ham
than good).  
Opportunity Costs per Statistical Life Saved
(OCSLS).
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Decision Making Style Questionnaire
Part One Circle the response that comes closest
to how you usually feel or act, and rate on the a
and b items of each statement on a 7-point scale.
There are no right or wrong responses to any of
these items. 1---2---3---4---5---6---7 Agree
Not Sure
Disagree 1. I am
more careful about a. Peoples feelings b.
Their rights 2. I usually get along better
with a. Imaginative people b. Realistic
people
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Decision Making Style Questionnaire
3. It is a higher compliment to be called a. A
person of real feeling b. A consistently
reasonable person 4. In doing something with
other people, it appeals more to me a. To do it
in the accepted way b. To invent a way of my
own 5. I get more annoyed at a. Fancy
theories b. People who do not like theories 6.
It is higher praise to call someone a. A person
of vision b. A person of common sense
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Decision Making Style Questionnaire
7. I more often let a. My heart rule my head b.
My head rule my heart 8. I think it is a worse
fault a. To show too much warmth b. To be
unsympathetic 9. If I were a teacher, I would
rather teach a. Courses involving theory b.
Factual courses
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Decision Making Style Questionnaire

• Part Two
• Which word in the following pairs appeals to you
  more? Circle a or b.
• 10. a. Compassion b. Foresight
• 11. a. Justice b. Mercy
• 12. a. Production b. Design
• 13. a. Gentle b. Firm
• 14. a. Uncritical b. Critical
• 15. a. Literal b. Figurative
• 16. a. Imaginative b. Matter-of-Fact

1---2---3---4---5---6---7 a little
somewhat
very
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Decision-Making Style Scoring Table
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Decision Styles
8 6 4 2
Intuition
Sensible Holistic
Rational Holistic
Decision Mode
0 2 4 6 8
Mixed Balanced
Sensible Analytic
Rational Analytic
Reason
8 6 4 2 0 2
4 6 8
Thinking
Decision Preference
Feeling
XY abs. (Feeling Thinking) abs. (Reason
Intuition)
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Decision Styles
Intuition
8 6 4 2
Decision Mode
0 2 4 6 8
Reason
8 6 4 2 0 2
4 6 8
Decision Preference
Thinking
Feeling
XY abs. (Feeling Thinking) abs. (Reason
Intuition)
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Decision Styles
Intuition
Decision Mode
Reason
Feeling
Thinking
Decision Preference