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What circumstances are relevant to decision making under uncertainty?
risk and rationality

by Matthew Leitch, 11 March 2009




The purpose of the study

The purpose of the study was to explore which factors people think are relevant to rational decisions under uncertainty. Factors used in the study came from these three groups:

Method

Participants in the survey were invited to join through two professional discussion lists, RISKANAL (for risk analysts) and Auditnet (for internal and external auditors) and given a link to a web page with the survey.

The survey itself involved one scenario, as follows:

Imagine that Bob is out one day when he meets Jill, who used to be a close friend but then moved away and dropped out of contact. (In fact part of Bob is still in love with Jill, and the meeting stirs up old feelings he thought had died.) When Bob and Jill get together later for a drink and a chat Bob learns that Jill is raising money for her new business venture. She is looking for money from a variety of sources but asks if Bob will guarantee some of her debt. This would involve agreeing to pay back some of Jill's loans if she can't, up to a maximum to be agreed up front. Jill will promise to pay Bob 5% of the amount he guarantees at the end of each of the first five years. After five years the contract will end.

In this deal Bob doesn't have to provide any money now, but he might at some point in the next five years if Jill gets into financial difficulty.

It's not the conversation Bob was expecting but the business idea is intriguing and based on a new gadget Jill says could save a lot of energy in homes all around the world. Bob agrees in principle but says he'll think about it and let her know how much he is prepared to guarantee.

All the following questions are about what factors you think should rationally affect how much Bob is prepared to guarantee.

Respondents were then asked to consider ten factors and say how relevant each was, choosing between 'Not relevant', 'Somewhat relevant', and 'Highly relevant'. Each factor was revealed only when the previous one had been rated.

Each factor was described in such a way as to make it fairly clear what was to be considered and to give some information about why the factor might be relevant to the decision. The descriptions were as follows:

"1. Should the prospects of Jill's business in comparison to the amount she borrows be relevant to the amount Bob decides to guarantee? It could be a great success or a costly failure leaving Jill unable to pay her debts. Is that relevant to a rational decision?"

"2. Should Jill's trustworthiness with money and desire to pay Bob be relevant to the amount he decides to guarantee? Jill could be a reliable person or a hopeless but loveable fantasist who lacks commitment. Is that relevant to a rational decision?"

"3. Should Bob's chances of spending more time with Jill and perhaps ending up living happily ever after together be relevant to the amount he decides to guarantee? Would it make a difference if she was already married or perhaps just getting over a divorce? Are Bob's opportunities with Jill relevant to a rational decision?"

"4. Should Bob's net wealth be relevant to the amount he decides to guarantee? Would it make a difference if he was a billionaire or nearly destitute? Is Bob's net wealth relevant to a rational decision?"

"5. Should the likely variability of Bob's income/wealth in future be relevant to the amount he decides to guarantee? Would it make a difference if he expected to be in a steady job, or be self employed (assuming equal incomes on average)? Is variability of future income and wealth relevant to a rational decision?"

"6. Should Bob's ability to deal with stress and to live happily without spending much money be relevant to the amount he decides to guarantee? Would it make a difference if he had medical problems that meant he was not physically strong? Is Bob's toughness relevant to a rational decision?"

"7. Should the amount of Bob's wealth held as cash or similar be relevant to the amount he decides to guarantee? Would it make a difference if he had a lot of his wealth as a reserve against a rainy day or instead lived life on maximum credit, always buying the best lifestyle he can afford at the time. If he had no money reserves then paying out for Jill would mean scaling back his lifestyle urgently. Is the size of Bob's money reserve relevant to a rational decision?"

"8. Should the contribution of Jill's business to sustainability be relevant to the amount he decides to guarantee? Would it make a difference if Jill's gadget was a breakthrough in carbon control or was, instead, a trivial gimmick? Is Jill's contribution to sustainability relevant to a rational decision?"

"9. Should Bob's personality be relevant to the amount he decides to guarantee? Would it make a difference if he was an extrovert with a love of fast cars or instead was an introvert who preferred card games (given equal spending habits, equal interest in romance, equal stress tolerance, and equal commitment to doing good)? Is Bob's personality relevant to a rational decision (leaving aside links to any factor previously mentioned in this survey)?"

"10. Should Bob's access to information about how Jill's business is doing during the five years be relevant to the amount he decides to guarantee? Would it make a difference if he had to wait for annual accounts or could check on the latest results and orders any month he chose? It might give him more warning of impending problems. Is Bob's access to business information relevant to a rational decision?"

Results

Most respondents who started the survey also finished it. Here are the respondent numbers for both sources:

Source of respondentsStarted surveyFinished survey
RISKANAL discussion list4743
AuditNet discussion list3734
Total8477

On the whole both groups of respondents gave similar ratings of most factors. It seems that:

The division of ratings by RISKANAL participants was as follows:

The division of ratings by AuditNet participants was as follows:

Importance of the results

These results have practical and theoretical importance.

The practical value is that, if you want to lead people in a discussion about an important decision to be made under uncertainty then:

You may find this more helpful than asking people to articulate their 'attitude to risk' or 'risk appetite'. I strongly suspect that these phrases tend to suggest that personal preferences, personality, and mood are the main concerns, taking attention away from practical circumstances. This in turn may leave people struggling to think how to answer the questions properly. I suggest it is better to be specific about practical circumstances and see which, if any, have important implications for the decision.

The theoretical significance is that these results begin to open up a wider range of factors driving decision making than has been considered in most theorising to date. Most attempts to model decision making under uncertainty assume an aversion to 'risk' per se or 'uncertainty' per se for reasons that are not discussed, or try to explain apparent aversion in terms of the shape of a utility curve applied to the outcomes of the decision. I think there's more to it and these survey results suggest that most people agree.

Further reading

'The real reasons we avoid risk' points out some practical circumstances that are often relevant to decision making with uncertain outcomes.

'Making sense of risk appetite, tolerance, and acceptance' discusses problems with some of the practices currently being advocated and clarifies a lot of terminology.





© 2009 Matthew Leitch
New website, new perspective: www.WorkingInUncertainty.co.uk - Related articles - All articles - The author - Services

If you found any of these points relevant to you or your organisation please feel free to contact me to talk about them, pass links or extracts on to colleagues, or just let me know what you think. I can sometimes respond immediately, but usually respond within a few days. Contact details

Matthew Leitch - Author

About the author: Matthew Leitch is a tutor, researcher, author, and independent consultant who helps people to a better understanding and use of integral management of risk within core management activities, such as planning and design. He is also the author of the new website, www.WorkingInUncertainty.co.uk, and has written two breakthrough books. Intelligent internal control and risk management is a powerful and original approach including 60 controls that most organizations should use more. A pocket guide to risk mathematics: Key concepts every auditor should know is the first to provide a strong conceptual understanding of mathematics to auditors who are not mathematicians, without the need to wade through mathematical symbols. Matthew is a Chartered Accountant with a degree in psychology whose past career includes software development, marketing, auditing, accounting, and consulting. He spent 7 years as a controls specialist with PricewaterhouseCoopers, where he pioneered new methods for designing internal control systems for large scale business and financial processes, through projects for internationally known clients. Today he is well known as an expert in uncertainty and how to deal with it, and an increasingly sought after tutor (i.e. one-to-one teacher). more

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