A Framework for Improving Decisions

Smart organizations can improve decision making in four steps:

1.  Identification
2.  Inventory
3.  Intervention
4.  Institutionalization



The four steps to improving decision making.

1.  Identification

Managers should begin by listing the decisions that must be made and deciding which are most important.

For example,

• "the top 10 decisions required to execute our strategy: or 
• "the top 10 decisions that have to go well if we are to meet our financial goals."

Some decisions will be rare and highly strategic. 

• "What acquisitions will allow us to gain the necessary market share?"

Others will be frequent and on the front lines. 

• "How should we decide how much to pay on claims?"

Without some prioritization, all decisions will be treated as equal - which probably means that the important ones won't be analyzed with sufficient care.



2.  Inventory

In addition to identifying the key decisions in 1 above, you should assess the factors that go into each of them.

• Who plays what role in the decision?
• How often does it occur?
• What information is available to support it?
• How well is the decision typically made?

Such an examination helps an organization understand which decisions need improvement and what processes might make them more effective, while establishing a common language for discussing decision making.


3.  Intervention

Having narrowed down your list of decisions and examined what's involved in making each, you can design the roles, processes, systems, and behaviours your organization should be using to make them.

The key to effective decision interventions is a broad, inclusive approach that considers all methods of improvement and addresses all aspects of the decision process - including execution of the decision, which is often overlooked.


4.  Institutionalization

Organizations need to give managers the tools and assistance to "decide how to decide" on an ongoing basis.

For example, the managers can be trained to determine whether a particular decision should be made

• unilaterally by one manager, 
• unilaterally after consultation with a group, 
• by a group through a majority vote, or 
• by group consensus.  

In addition, they can also determine

• who will be responsible for making the decision, 
• who will be held accountable for the results and 
• who needs to be consulted or informed.

Companies that are serious about institutionalizing better decision making can often enlist decision experts to work with executives on improving the process.

For example, the members of a decision analysis group can

• facilitate framing workshops; 
• coordinate data gathering for analysis; 
• build and refine economic and analytical modes; 
• help project managers and decision makers interpret analysis; 
• point out when additional information and analysis would improve a decision; 
• conduct an assessment of decision quality; 
• and coach decision makers.

Regularly assess and review to improve the quality of your decision making.

An organization that has adopted these four steps should also assess the quality of decisions after the fact.  The assessment should address not only actual business results - which can involve both politics and luck - but also the decision-making process and whatever information the manager relied on. 

The organization should regularly performs "look-backs" on major decisions, and assesses not only outcomes but also how the decision might have employed a better process or addressed uncertainty better.

The Hidden Traps in Decision Making

Making decisions is one of the most important things we do in our daily living.  It is also the toughest and riskiest in some situations.  Bad decisions can damage your career, business and finances, sometimes irreparably.



So where do bad decisions come from? 

In many cases, they can be traced back to the way the decisions were made:

• the alternatives were not clearly defined,
• the right information was not collected,
• the costs and benefits were not accurately weighed.

But sometimes the fault lies not in the decision-making process but rather in the mind of the decision maker.  The way the human brain works can sabotage our decisions.

Psychological traps

There are a number of well-documented psychological traps that are particularly likely to undermine decision making.  These include:

• heuristics#, 
• biases and 
• other irrational anomalies in our thinking.  

Your best defense is AWARENESS

There are specific ways you can guard against them.  However, the best defense is always awareness.  

By familiarizing yourself with these traps and the diverse forms they take, you will be better able to ensure that the decisions you make are sound and that the recommendations proposed by others (your subordinates or associates) are reliable.

Additional notes:

#heuristics:  

These are unconscious routines we use to cope with the complexity inherent in most decisions.  These routines serve us well in most situations.  These simple mental shortcuts help us to make the continuous stream of judgments required to navigate the world.  But, not all heuristics are foolproof.  The resulting decisions often pose few dangers for most of us, and can be safely ignore.  At times, the decisions arising from these heuristics can be catastrophic.  What make all these traps so dangerous is their invisibility.  Because they are hardwired into our thinking process, we fail to recognize them - even as we fall right into them.

Investment Decisions and Fundamentals of Value

@ 6.47 min
Managers should invest in real assets and should not be involved in investing in financial assets which the shareholders can do on their own.


What is a Valuable Investment Opportunity?

1. An investment worth more than it costs.
2. An investment with a return greater than its opportunity cost of capital.

Why does an asset have value?

1. An asset provides a return on investment in the form of future cash payments.
2. When we make an investment, we are buying a cash flow stream.
3. When we assess the value of an asset, we assess the value of its cash flow stream.

Asset valuation is the answer to the following question:

What is the PRESENT VALUE of a Future Cash Flow Stream?

@ 13 min

What determines the present value of a cash flow stream?

1. Magnitude
2. Timing
3. Risk

@ 15 min

Risk of the cash flow stream

Consider 2 cash flows streams A and B

A pays $100 for certain.

B may pay as much as $100 but may pay as little as $60.

Choice:  Choose A

We are risk adverse.  A SAFE dollar is worth more than a RISKY dollar.

@ 17 min

Time Value of Money

Time value of money is the rate of exchange between present dollars and future dollars established in the financial market.

Time value of money is reflected in the rates of return available to all investors in the financial markets.

@ 18.30

Risk and Return Relationship

Safe dollars are more valuable than risky dollars

Risk averse investors prefer safe investments.

How do you induce risk averse investors to take a risky investment?

Risky investments must promise higher returns to induce investors to undertake them.

In the financial markets, investments are priced so that the higher the risk, the higher the expected return.

Risky investment's rate of return reflects a risk premium that rewards investors for taking on the investment's risk.

Investment's opportunity cost of capital is the return forgone on an investment in the financial market of comparable risk.

Riskier investments have higher opportunity costs of capital.

Rate of Return = Time Value of Money + Risk Premium

Rate of Return = Risk Free Rate + Risk Premium

@ 21.30

Value of an asset:

1.  Forecast the magnitude and timing of the cash flow stream over its economic life.

2.  Assess the risk of the cash flow stream.

3.  Value the cash flow stream given its magnitude, timing, and risk at its opportunity cost of capital.

Market Value and Rate of Return

@ 23 min

The cash flow stream's value is determined by the amount of money needed today to recreate its magnitude, timing, and risk in the financial market at its opportunity cost of capital.

@ 24.50

What is the investment's opportunity cost of capital?

PV = FV / (1+r)

The value of an investment asset is the money needed today to recreate its future cash flow stream in the financial market at its opportunity cost of capital (r).

The value of an investment asset is the present value of its future cash flow stream.

How much is the asset worth, and how much does it cost?

• What is the value of the asset's future cash flow stream today, and how much does it cost?
• What is its PRESENT VALUE, and how much does it cost?
• What is the prevent value net of cost?
• What is its NET PRESENT VALUE?

NPV = PV of Investment - Cost

A valuable investment opportunity is worth more than it costs.

@ 31 min

If 

NPV > 0, investment is worth more than it costs

NPV < 0, investment costs more than it is worth.

NPV =0, investment costs as much as it is worth.

NPV is the absolute dollar change in wealth from the acceptance of an investment opportunity.

Look for investment opportunities in those with positive NPV projects.

What is a valuable investment opportunity?

1. An investment with a net present value greater than zero.
2. An investment with a return greater than its opportunity cost of capital.

Investment Decision Rules

1. Accept all investments with Net Present Values greater than Zero.
2. Accept all investments with rates of return greater than their opportunity costs of capital.

@ 34 min

Example using the Net Present Value Rule

NPV = PV - Cost 

> 0, therefore we accept the project.

@ 35 min

Example using the Rates of Return greater than their Opportunity Cost of Capital

Rate of Return = 20%.

Opportunity cost of capital = 12%.

Therefore, accept the project.

@ 36.50

You are considering an investment opportunity that costs $100,000 and promises to return 10%.

A comparable investment in the financial market returns 15%.

A bank offers to lend you $100,000 at 8% with no conditions.

Do you invest $100,000 in the investment opportunity?  NO.

Financing cost = 8%.

What is the investment's cost of capital? 15%.

The cost of capital is the return on comparable investments in the financial market, that is 15%.

The cost of capital is not the cost of raising the money to finance the investment.  That is a financing decision and not an investment decision.  

That return in the financial market is the standard against which other investment opportunities are evaluated.

The financing by the bank loan is irrelevant to the investment decision.

Investment decision and financing decision are separate and independent decisions.

First make the investment decision, after that, then make the financing decision.

Thanks for pointing this video out to me.
<  I found these very helpful : https://www.youtube.com/watch?v=ZtQKrPBz3XA https://www.youtube.com/watch?v=4q2Xcbrazhw on Financial Ratio Tutorial Anonymous on 4/7/13 >

When things go wrong: The smart organisation

Consultants and researchers David and Jim Matheson identify research and development (R&D) as a key area of decision making for business success.  R&D decisions affect any areas where innovation (rather than improvement) is required.  This principally means creating and marketing new products and services, but also includes designing the new processes and systems that will make them possible.  'Processes' could mean manufacturing processes, but it could also refer to strategically critical aspects of the business, such as its decision making processes.

Essentially, R&D is about ensuring that the business moves forward.  As we have seen, potential strategic risk downsides include

• failing to innovate,
• failing to achieve renewal, or
• putting processes in place that fail to allow for the right kind of development.

The Mathesons suggest three levels of 'smart' R&D:

Technology strategy:

• How will you support existing products, generate new ones and develop radically new ones?
• Will technology be developed or supplied from inside or outside the business?
• What skills are required?

Portfolio strategy:

• Which R&D projects will be funded?
• Which will not?
• How will resources be allocated so that they provide the best R&D value?
• How will you balance short-term business needs with long-term renewal?

Project strategy:

• How will you ensure that each individual project delivers maximum value?
• How could commercial concerns (as well as technical, budget and timescale issues) be brought in?

Nine principles of smart R&D

They also propose nine principles of smart R&D, or the attributes that businesses need in order to be capable of making strategic decisions:

• Value creation culture:  the business has a purpose that everyone understands; this purpose is the test of whether strategies and actions will deliver value for the business and its customers.
• Creating alternatives:  for each decision, there must be a good set of competing alternatives; these must be created if they don't exist or aren't apparent, and carefully evaluated
• Continual learning:  change is certain, and everyone must learn from new situations and information rather than feeling threatened by it.
• Embracing uncertainty:  since there are no facts about the future, everyone must learn to live with and recognize uncertainty, measure and evaluate it, and understand what they are doing.
• Outside-in strategic perspective:  rather than thinking about where the business is and then where it should be going (inside-out), consider the big picture first and work back to the business (outside-in)
• Systems thinking:  use tools and techniques (such as the decision tree) to simplify the complexities involved in strategic decisions as far as possible and enable insights (but not so far that objectivity is lost)
• Open information flow:  any type of information may be important, so information needs to flow, unrestricted, to all parts fo the business, the habit of hoarding information as a source of power must be driven out.
• Alignment and empowerment:  rather than micro-managing every action through 'command and control' systems, aim to involve people in decision making through participation, while building alignment through common understanding of goals
• Disciplined decision making:  build processes that recognise the need for strategic decisions to be made before it is too late; then apply systematic, disciplined processes to making those decisions.

The Smart Organisation: by David and Jim Matheson

When things go wrong: Lessons for decision making

When things go wrong, an important area of learning is the decision-making process itself.  With the benefit of hindsight, you can consider how efective your processes for making decisions were.  Consider questions such as:

• how likely is it that you were influenced by a taken-for-granted frame?
• do you need to rethink the way you regard risks (i.e. as opportunities or threats)?
• are there any lessons in terms of the way you regard outcomes (i.e. as gains or losses)?
• did you identify all the alternatives, or has it become clear that unconsidered alternatives would have been better?  how can you ensure that your future decision-making frames cover these alternatives?
• what information has come to light that could help to reduce the subjectivity of your probability assessments in futures?
• how can learning be enshrined in the business and made easily available and usable for future decisions?
• are downsides and/or upsides in line with expectations? are there any unforeseen dimensions or knock-on effects in the outcome?

For any of these questions to be answered effectively, it's crucial that you have an objective record of your original decision making processes.

When things go wrong: Towards better decision making - measuring success

What to use to measure success - quality of decision making or results?

The implications for businesses are profound.  If it is the quality of decision making , rather than results, that are the measure of success, then those who take decisions in the right way should be rewarded, even if they make mistakes.  They should also be given more decisions to make in the future, not fewer.

This doesn't mean automatically promoting people who get bad results.  it means:

• encouraging better decison making and making it clear that it will be rewarded
• setting boundaries to limit the impact that mistakes can have; acknowledging and actively managing the risk of mistakes
• avoiding or limiting exposure to fatal downsides (doctors and airline pilots, for example, need systems to help them avoid errors)
• when rewarding people, considering the way decisions have been taken as well as the results of decisions
• questioning the business benefit of punishing those who get bad results
• weighing the negative impact of mistakes against the learning and development they can bring.

It is important to remember that none of this means ignoring poor results or mistakes.  Financial loss or commercial reverses are bad for business.  But failing to learn can be worse.  The focus of management has to be the future, and what can be learned from the present and past to help shape the future.  By focussing on learning and better decision making, the business is doing everything it can to do to avoid bad result in the future, rather than simply reflecting what has happened in the past.

When things go wrong: Towards better decision making - quality of decision and the role of chance

Business results are the outcome of the interaction between our decisions, our actions and chance. Even if we make no error, there is always the cahnce that a bad outcome will result from a 'good' decision. For example, we might play dice game version A (http://spreadsheets.google.com/pub?key=te9MzyHoIN6EyuoHmfDxMaw&output=html) ten times and lose every time, despite having established that hte risk had a positive expected value. But how would such a decision be regarded in business?

 

If we were rewarded solely on results, with no attention paid to the way we took our decisions, our $10 loss would look pretty bad.  Our performance report might read as follows:  'Despite your poor results, you played this game again and again, throwing good money after bad on the off-chance of things somehow coming right.  You recklessly gambled company money on an uncertain future.  Your poor results are evidence of your bad judgement.  What were you thinking?'

 

But if we were rewarded on the quality of our decision-making process, our actions would appear in a very different light, resulting in a different review:  'Although results have been poor, due to circumstances beyond your control, the quality of your decision making was excellent.  You obtained all the information that you could on possible outcomes, and the probabilities of each, and took a decision on that basis.  The negative results, though disappointing, have not bankrupted the company.  You will be rewarded on the basis of decision-making quality.'

 

The flip side of this is that people might make decisions on impulse, or randomly, and still get good results by chance. 

• By rewarding or promoting these individuals, the business risks having lucky managers rather than competent ones - fine, until their luck runs out. 
• Also, although spontaneous decisions may turn out to bring some business benefit, they don't teach us anything.  We can't use them to improve the way we take decisions, or to instruct others.

When things go wrong: Towards better decision making

In business, we tend to judge people by the results of their actions.  Many performance management systems are oriented in this way, placing a strong emphasis on management by results.  Realise upsides and you reap rewards and promotion; realise downsides and you are blamed and maybe even fired.

To most managers, this seems a natural way to 'encourage' and 'motivate' people to 'improve'.  If we reframe the argument in terms of decision quality, rather than result quality, the picture changes.  People's 'mistakes' indicate that they are willing to make decisions, and it is only by making decisions and observing the results that we can improve.  We learn about novel, unfamiliar or complex things through experiment and error.

A study of financial traders showed, it is a serious error for decision makers to assume that bad results mean a bad strategy, just as it is to asume that making money was because you have a good strategy.  In business, as in markets, luck plays a part, and the best managers are like the best traders in having an accurate and sufficiently modest view of which results to attribute to skill, and which to serendipity.

Business results are the outcome of the interaction between our decisions, our actions and chance.  Even if we make no error, there is always the cahnce that a bad outcome will result from a 'good' decision.  For example, we might play dice game version A (http://spreadsheets.google.com/pub?key=te9MzyHoIN6EyuoHmfDxMaw&output=html) ten times and lose every time, despite having established that hte risk had a positive expected value.  But how would such a decision be regarded in business?