Decision Making Under Uncertainty
We all make millions of decisions throughout our lives, from trivial ones such as what to eat for lunch to more important ones such as whom to marry, what investment to make, and what career to choose, etc. The main issue is not the decision itself but its consequences in the short and the long run. In the business world, decision-making is at the heart of leadership because making the right call at the right time can make or break a business. Therefore, making the right decision is of paramount importance. But how do we know how to make good decisions, and by the way, how do we qualify a decision as good or bad?
A good decision can be defined as taking the best option given the available information at a specific time to maximize the expected utility. In other words, we do things because we want to reach a certain objective. Some people make this the defining feature of rationality.
As much as this definition is mathematically beautiful, a closer look requires a bold assumption. It implies that people weigh in several researched options and make a decision to increase the likelihood of the desired outcome. There is a problem, though — a very big one. Most of the time, we don’t always have the time to analyse available information, let alone have the right information. Also, in an ever-complex and changing world that produces vastly more noise than signal, it is very hard to select what to factor into the decision process.
In the last 50 years, behavioural science has been heavily studying how people make decisions under uncertainty. The work of two psychologists, Daniel Kahneman and Amos Tversky, has really revolutionized the way we understand human behaviour. The first has won the Swedish Bank prize in the memory of Alfred Nobel. Thousands of papers have been written and countless books have been published in this area. It also gave birth to behavioural economics, or how people make decisions that involve money. Richard Thaler, Daniel Kahneman’s student, won the same prize in 2017 for his work. He even went so far as to suggest some actions that people should follow in order to “nudge” toward the “right direction” as a libertarian paternalist would do.
This side of behavioural science, the most popular nowadays, found out that people use several shortcuts, also called heuristics, to make decisions. Availability, anchoring, confirmation biases, and many others have been described by the proponents of this field. Some went even further to say that people behave irrationally. It was a bold departure from homo economicus of the neoclassical economics theory. In the business world, some authors suggested developing leaders as choice architects who would be able to identify the source of such heuristics and work to correct them “rationally.”
It is worthy of note that this field has been built on two main theories: the expected utility theory and prospect theory, both of which basically state that people make decisions to maximize their utility given their state of wealth. It explains, for example, why people have a natural tendency to avoid losses purely because for the same amount, the loss hurts more than the gain.
This view of behavioural science has recently been challenged by the field of Ergodicity Economics (EE) and its proponents: Ole Peters and researchers of is coined the Copenhagen experiment. The main issue resides in the fact that it assumes that people make decisions in a world with additive dynamics which do not resemble the real world, more inclined to have multiplicative dynamics. The field of EE is starting to show that what mainstream behavioural science sees as irrational, turned out to be rational behaviours in a dynamic and complex environment, especially when one takes long-term consequences into account. The perfect example is the loss aversion heuristic which turned out to be a perfect strategy to avoid ruin in the real world.
This has led to a whole lot more interesting story about decision making and the related payoffs where some see biases and irrational behaviours, others see rules of thumb helping people navigate a world they don’t understand with a primary focus on survival.
Gerd Gigerenzer, a vivid opponent of Daniel Kahneman’s work, explains that there are three domains that people need to consider when making decisions: certainty, risk, and uncertainty. The first one belongs to the realm of hard sciences. Let’s take Newtonian physics, for example; the law of gravity belongs to this area. You are pretty much sure that if you jump out of the 20th-floor window, you will end up in the cemetery. The second domain is where risk can be easily calculated. This can be found in casinos and game theory. The third domain, called uncertainty, deals with unknown unknowns widely found in business, investment, health, and the real world in general. There is no way we can compute the risk and plan the consequences. Therefore, Gerd Gigerenzer suggests using rules of thumb and intuition to deal with the uncertain domain. This reminds me of the conscious and unconscious duality and the fact that every second, 11 million pieces of information are received by the human mind, only 40 of which are really processed consciously. The question is, where does the rest go? Maybe they are perceived effortlessly by our adaptive unconscious from which they are retrieved and transformed into conscious behaviour to deal with an a priori ambiguous and complex situation.
The world we are living in today is more complex than ever. The interconnectedness of its components is increasing exponentially. Making decisions in such a world is not an easy task. However, I don’t think it is much harder than millennia ago when knowledge was much less available. People used to heavily rely on institutions and used their institutionalized rules to deal with complexity, and religion was the perfect example. Today, we need to be aware of what we know and what we don’t know and be more prudent about things we know for sure and avoid the epistemic arrogance as coined by Nassim. Second, we need to make sense of our context to adapt our behaviour and be conscious of the environmental dynamics. In more complex domains such as business, being aware of the first-order errors or biases can be helpful, but one should follow rules of thumb to help avoid ruin and be exposed to exponential payoffs.
