Decision

Making Frameworks,
& Their Pitfalls
System 1 and System 2 Perspectives

Suri Gurumurthi, Ph.D.

September 2017
 System 2: Decision Framework
Alternatives
Were a sufficient number of alternatives
considered?
Were the differences between alternatives
explored?
Outcomes
Are they very different from estimation? Outcomes

Were they considered or not?

Their overall impact, over time
Process Alternatives

Did they involve the right people?

Did they have the right structure?
Risk Process Risk

Did they account for possible risks?

Did they over or underestimate the risks?
2
 System 2: Alternatives
A set of different possible decisions Decision Alternative A Attribute 1

Alternatives have to be developed! Attribute 2

Without alternatives, a decision is just an
action Alternative B Attribute 1
Alternatives have to be clear
Alternatives could sometimes be laid out in Attribute 2
sequence i.e. what-if scenarios
Examples
Should we buy our competitor or develop
similar products? Google bought Youtube, a
big success!
How many different models of iPhones should
Apple introduce next?
Alternatives have to have distinguishably
different attributes or features
Otherwise decision-making is made harder!
3
 System 2: Outcomes
A set of possible states reached with the Outcome 1
alternatives
Alternative A
For e.g. success or failure or somewhere in
between! Outcome 2

Outcomes may or may not be observable for Decision

e.g. satisfied or unsatisfied customers
Outcomes may not always be measurable Outcome 3

for e.g. the extent of satisfaction of customers Alternative B

Examples Outcome 4

What would be the demand for an iPhone 7

vs. 7Plus? Measurable & observable
What would be the impact of economic
reforms in Greece? Not all outcomes may be
measurable or observable in the short run.
What would be the state of happiness with a
new car purchase? Outcomes may change
with use and time.
4
System 2: Risk and Uncertainty
Life is uncertain, but
So is business and the economy
But uncertain does not mean leave decisions to
pure chance
There can still be some influence over
outcomes
Decisions aim to reduce uncertainty
We often make decisions to reduce uncertainty
in both action and outcomes
Good decision-making takes calculated risks!
Risk Tolerance
The more we know about the outcomes the
less risk we face
However, not everyone is identical in how
much risk they prefer
Decisions can be taken to minimize risk, or
maximize reward risk vs. reward
5
 System 2: Process
An approach to the decision-making
A process is typically well-defined Objective Reasoning Subjective Reasoning
But sometimes may be ad-hoc or unplanned
May involve rational or irrational decision-makers
Requires and incorporates information
Incorporates
Emotion
Subjective vs. objective measurement

Subjective decision-making invokes human emotion,

judgment, and experience
Eliminates bias Experience
Objective decision-making follows a set logic
Neither objective nor subjective works in every case
good decision making often blends the two
approaches Based on logic Uses judgment

Consensus vs. Hierarchical

Hierarchical decisions are enforced top-down
Consensus looks for agreement

6
System 2: PrOACT Decision Making Model

Objectives
A good solution to a well-posed
problem is often more effective than
an excellent solution to a poorly posed
problem!

Trade-offs Problem Alternatives

Consequences

7
 System 2: Other Decision-Making Strategies

Improving System 1
Optimization Satisficing
Decision-Making
Sub-optimization good enough while Decision Counseling
Prescriptive vs meeting minimum Preparing for Post-
descriptive requirements decisional setbacks
considerations Acknowledging Counteracting
Simulating or Bounded Rationality Defensive Avoidance
Projecting Outcomes Process of eliminating Preventing group-
Choosing best path bad alternatives think
Incremental
improvements
System 1: Decision-Making and Stress

Stress is a key factor in quality of decisions

Think Exams!
We are often simultaneously for and against alternatives
Decisions are also taken to eliminate/mitigate the stress
Stress can also be precipitated by knowledge of risks associated with decision
alternatives
Personal decisions can therefore be harder
Consequences are felt personally
Conflict can also impair decision-making
For e.g. panic-attacks when asking a person out for a date!
Defensive avoidance
Avoiding decision-making to postpone negative consequences/risks
System 1: Decision Illusions

Human beings are incredibly flexible decision-makers

However, we do not process information perfectly
Visual Illusions
How we make choices visually
We are averse to decision effort
24 jams vs 6 jams example
Costco vs Wal-Mart
We are biased in our decision-making
We do not admit mistakes!
 System 2: The Expected Value Criterion
Outcome O1,
Value V(O1)
Probability p1

Outcome O2,
Alternative Value V(O2)
Probability p2

Outcome O3, Outcome O1,

Value V(O3) Value 20K
Probability p3 Probability 0.2

Expected Value = p1 x V(O1) + p2 x V(O2) + p3 x V(O3) Outcome O2,

Invest $10K Value 12K
Probability 0.6

Outcome O3,
Value 5K
Probability 0.2

Expected Value = 0.2 x 20K + 0.6 x 12K + 0.2 x 5K = 4K + 7.2K + 1K = 12.2K

11
 Expected Value Criterion or Objective
Powerful guide to decision-making
Bad Decisions
Not perfect, it is only a first order
objective
Need to incorporate risk tolerance (look
at the variance!) Under or over- Under or over-
Under or over-
estimating value of estimating probability
Unfortunately, we cannot estimate estimating outcomes
outcomes of outcomes
very well any of the elements of this
criterion
We are not good at estimating Not accounting for all Not sure of how to Estimate based on past
probabilities! possibilities attach value or utility observation

We are not good at estimating

outcomes!
We are not good at estimating the value Inflating or deflating
of outcomes! Valuation changes Rely on limited sample
consequences

12
Are Chimps Really Smarter Than Humans?
Not really Chimpanzees cant reason as well.
But reasoning comes with its own pitfalls.
One can develop the wrong reasoning!
Anchoring
The phenomenon by which our decisions and choices are guided by
past information (which could be potentially misleading).
Bias
The phenomenon by which we apply our pre-conceived judgments and
notions to current decisions and choices

13
 Anchoring Trap & Its Causes
Googles stock price was $659 on Aug 17 Incomplete information, stereotypes, and past
2015. IBMs stock price was $156 on Aug 17 trends (Dr. Roslings Chimpanzees dont know
2015 the trends!)
Does Google have larger revenues than First data point
IBM? For e.g. when we buy clothes we look at the list
No. Google had revenues of $66B (growing) price as a quality indicator, when it should be the
IBM had revenues of $92B (declining) final discounted price!
Anchoring This is very common as a sales tactic anchor the
customer to the starting price!
The phenomenon by which our decisions and
choices are guided by past information (which Techniques to limit anchoring
could be potentially misleading).
Multiple sources of information
The missing information here is the growth Multiple perspectives (solicit after examining ones
of the company own)
Often we either dont have the missing Entering negotiations with an open mind
information or we stop searching for the extra Ascertain value of products and services before
information! evaluating the price or discount
14
 Status Quo Trap & How to Overcome It
We dont like change! While status quo may indeed be a better
Principle of least resistance and effort
option
Dont prefer it just for comfort factor
Change requires some setup and investment Look at the change alternatives!
There are still CEOs who do not know how Think, or re-think the objectives
to email! Many times the objectives might have changed!
People still subscribe to print newspapers The best companies fail because they still persist
with the right product for an earlier time.
Investors are more inclined to buy stocks Think Kodak and film cameras!
rather than sell them Think in terms of fixed costs and payoffs over
time
This is the reason a surprisingly large A net present value approach
number of executives get fired! Hire and partner with people with fresher
Even Steve Jobs got fired for wanting to ideas
perpetuate his Holy Cow product at Apple Sometimes the best way to sweep away old
ideas is to bring in new ideas

15
 Sunk-Cost Trap
People dont want to admit mistakes
For example: not firing a wrong person
for a job
Re-hiring can be expensive
Solicit advice from unbiased people
People dont always sell their stocks Net Present Value framework
when the share price drops Compare the costs over time of action vs.
Even when the expected return is negative inaction
Difficult decision to cut your losses When you are in a hole, stop digging
Half of all large Information Technology Change the people
projects ($15M or more)*
Take a one-time hit, and move on
Are 45% over-budget Microsoft shut down its businesses acquired
Deliver 56% less value than initially from Nokia within 2 years (similar story to
projected Google after it acquired Motorola)
Time Warner spun off AOL after 7 years!
*Delivering large-scale IT projects on time, on budget, and on value, McKinsey 16
Insights, Oct 2012.
 Confirming-Evidence Trap
We (and businesses) tend to seek out Seek out opposing points of view
information and evidence to confirm our For example in 2008, President Barack Obama
existing point of view hired a team of rivals in his cabinet many of
For example, less than 2% of climate scientists whom had opposing views on key policies
believe that global warming is not caused by
humans He won re-election in 2012 by a handy margin
Still most of the world governments and their Be honest with ones own motives
leaders still consider this a valid debate, they
cite the 2% of scientists who say humans may For e.g. companies merge for the wrong
not be the cause. reasons; executives get a fat bonus after a
merger, successful or not!
There are two ways we make decisions
Instinctively based on what our brains Hire people who have the courage to disagree
present to us as a context Companies now have a suggestion box for
Slower reasoning based on information and internal complaints and dissent; they also
decisions made over time protect whistleblowers
Many of us subconsciously seek to affirm our
instinctive decisions Find an independent consultant or agency
We also look for information that we like who can help you make objective decisions,
especially for the big ones!

17
 Framing Trap
Problems or questions can be stated or Spend more time posing the decision
posed incorrectly problem (recall PrOACT)
Organ donor example A problem well posed is half-solved already
Greek bailout referendum example of 2015 Be neutral as far as possible in framing
Most Greeks rejected the bail-out from the
Troika the problem
But most Greeks also wanted to stay within the While gains are preferred, they can also
Euro-zone lead to poor decisions
Question was not clearly posed to voters Do what-ifs
People prefer options resulting in gains Would your decision change if the question
rather than options resulting in lower were differently posed?
losses Provide as much data as possible in the
Framing trap is also possible via reference problem itself
points

18
Estimating and Forecasting Example Place your vote!
It is the Year 1992
Number Sold: Number Sold:
4,000 4

19
 Estimation and Forecasting Traps
Overconfidence Trap
Difficult to estimate high and the low limits
We predict narrower range of outcomes
We dont see the extremes often!
Prudence Trap
We have thumb rules for safety
For e.g. the average US savings rate is around 5%
Uniform and not progressive income tax rates
Recallability Trap
We sometimes inflate the occurrence of adverse There is no golden charm for decision-making
events.
Based on recent observations
Typhoon = Climate Change!
Start at the extremes
Outlining the best case and worst case
scenarios first can help minimize
overconfidence and narrow ranges
Be wary of thumb rules of protection
against risk
Evaluate each problem on its own merits, rather
than using thumb rules
Rely on statistics in the presence of data,
seek out statistics in the absence of data
There is no crystal ball
There may not always be easy solutions to
difficult problems!
Know and accept the risk of being wrong!
20