September 30, 2010

Decision /making 101

It seems that in our day-to-day life that we use words like always,never, and 100% positive. In actuality we are usually only partially, or not at all, right. We say things as if we know what we are talking about, when in actuality we don't know anything about the subject at hand. If we can take the knowledge that we don't know everything, and apply it to economics, we can acquire a much greater understanding of the economy. When Itzhak Ben-David of Ohio State University, and Sand John R. Graham and Campbell R. Harvey of Duke looked at the decisions of some of the major American Corporations, they found the same situation.
Most CFO's in the U.S. are not very good at forecasting the future of their corporations. This may be because they don't have enough understanding of the economy, they assume to much about the economy and their business, or that they simply do not acknowledge important factors and information in their businesses. When they expressed their 80% confidence limit, they were only right 1/3 of the time. This means that if we were asked what we think the returns were supposed to be on our hypothetical business, we would have either a 10% higher return, or a 10% lower return, than we predicted. To top that off, these predictions were negatively correlated with their stock returns. This means that the lower limit of their prediction made a positive correlation, and vice versa.
It seems obvious that they can't predict correctly, because if they could they would all be billionaires. The troubling factor is that as a whole, they do not realize the lack of forecasting ability that they have. The economists, stated above, said that things feel more uncertain in rough times, but when the worst prediction made was simply a flat market, we are only hoping for the best, when in actuality the market may plunge.
The reason CFO's, and the rest of us, make these wrong decisions, is because we suffer from overconfidence. The trait most of us do not suffer from, but the CFO's do, is narcissism. Although we have confidence in ourselves, we acknowledge that mistakes can be made, and that bad things can happen. When the thought that we can do no wrong is inserted in our minds, we seem to commit more mistakes, and more errors are made. Once we consider that we may not have done the best, most optimal, job, we can accept failure, and even make better decisions to begin with.

Mark Twain once said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

1 comment:

Larry Eubanks said...

I'm thinking your suggestions about overconfidence and wrong decisions are not quite the best way to see these issues.

The future is uncertain. We can guess the future, be we cannot resolve that uncertainty about the future in our present.

Decisions today that result in not quite what was expected, I think, could still have been a good decision, given uncertainty.

Now, given uncertainty, one might wonder why our present inability to predict the future doesn't lead to widespread shortages and surpluses with market allocation of resources?