Wednesday, July 6, 2016

How To Make Decisions

A reporter recently sent out an open call for input for an article he was writing about how to make good financial decisions.  Since I don't know if he will use any of what I said in his article and since I kind of liked my answer (even though I know it is not complete), I thought I would drop it here as well.

While most people think about espionage when they think about intelligence, an analyst is the person in an intelligence organization that makes decisions about what the other guy – the enemy, the criminal or the competitor – is likely to do.  These kinds of decisions are the hardest kind, with incomplete and potentially deceptive information and under conditions of extreme time-pressure and uncertainty.  

Financial decisions, particularly those made by individuals or small business owners are often very similar to these kinds of decisions (albeit with lower stakes).  As a result, virtually all of my research is also applicable to the kind of decision-making that is important when it comes to finances. 

I know you are going to get lots of advice but I have two items that I think are often overlooked.  The first is to separate what we call intelligence questions from operational questions.  

An intelligence question is a question about something that is important to your success or failure but is outside your control.  An operational questions is about something that is important to your success or failure but is under your control.  You analyze these two kinds of questions differently. 

Things that are under your control are much easier to analyze.  You usually know the data or you know where to get it.  You have some understanding of how much uncertainty exists in the data and how much of it you can weed out with statistics or whatever methods you use.  

With things that are out of your control – what your competitor is going to do or how the price of oil is likely to change or how low will the used car salesman go – you have to use a different set of tools and skills to understand these kinds of questions.  There is much more uncertainty here and it is much more difficult to narrow it.  In addition, there is likely some degree of deliberate deception going on – think about the used car salesman and how he or she is trying to sell the features and not the flaws of his 2006 Camry.

Second, the important skill to develop in answering these type of questions (particularly intelligence questions) is estimation.  Collecting facts is important, indeed essential, to answering questions but it is easy to fall victim to collecting facts simply for the sake of collecting them or to give into various cognitive biases which can easily make whatever time and money you spend collecting facts worthless.  

Since understanding what is likely to happen next is more important to planning than understanding what is happening now and since most of the future is more or less unknowable, the ability to make a good estimate is critical to good decision-making.  

Philip Tetlock has done fantastic research on this as has Douglas Hubbard.  I recommend both of them to your readers.