If you have ever made a decision that didn’t work out as you had hoped, it probably just leapt into your mind, perhaps accompanied by cold sweats or a shiver down your spine. Sorry about that! But maybe I can make you feel a bit better by asking the question: ‘how do we know if we have made a bad decision?’
In my second article on decision-making (you can find the previous article here), we explore these ‘bad’ decisions more deeply.
The instinctive reaction is that a bad outcome is the result of a bad decision, but this isn’t strictly correct. Outcomes are subject to uncertainty, or luck. When we make a decision, we don’t have perfect knowledge of the future, so all decisions are based on our forecasting – and sometimes those ‘unknown unknowns’ occur (i.e. bad things happen). For example, one country invades another, which has a large impact on future outcomes.
Arguably, the invasion of Ukraine by Russia was foreseeable (though this is ripe with a variety of biases, which I’ll discuss in a later article). With a small number of exceptions, the world’s press were convinced that Russia wouldn’t actually invade. Even if some people did expect Russia to invade, how many thought through the consequences and acted upon them? Most of us seem to have been taken by surprise by the rapid changes this has caused. Aside from the awful consequences for Ukrainians, those not directly affected by the war have suffered a massive increase in energy prices, impacting businesses and households alike.
So what makes a decision a good one?
A good decision is one that is properly considered; one which ensures we have taken all the prior knowledge we have into account (or the knowledge that is worth acquiring) and which, having done that, we consider to have an acceptable risk/reward balance. The outcome is still uncertain, and may not be as we had wished, but a poor outcome doesn’t necessarily mean we made a bad decision. If we made an informed decision based on all the relevant information, it was a good decision, but with a bad outcome.
Not every decision will go our way unless we are being extremely cautious. In which case, we are probably passing up many good opportunities. It is therefore essential to take a portfolio view of decisions, rather than ‘betting the farm’ on a single decision. To do so is high risk (putting all your eggs in one basket) and, I would argue, a poor decision.
With many decisions, things may not work out as hoped. Let’s start with a personal example. If you turned down a job offer and then later got made redundant at your current job, you might think that was a bad decision. But you could only really be sure if this decision was good or bad if we could run two parallel lives and see how things turned out in both of them. If you had taken that job, you might have hated the culture or found the work dull. It’s hard to know for certain.
Was it really a bad decision just because it was a bad outcome?
So what about investment decisions? Surely we know if these are good or bad? At least, we should know if they’re bad; if we made an investment decision and lost money, wasn’t that a bad decision? Not necessarily. We need to differentiate between bad decisions and bad outcomes.
One key thing to remember with decision-making is uncertainty. Uncertainty can cause discomfort and stress, and we would much rather have a straight yes or no answer to many questions than a probability. Weather forecasters tell us the percentage likelihood of rain, but we just want to know whether to take an umbrella.
The fact is, we need to become more comfortable with probabilities and uncertainty. Sophisticated investors take various measures to deal with uncertainty by spreading risk across multiple investments through hedging, as well as insuring against certain types of loss.
When we hear about uncertainty and probabilities, we need to be careful to control our natural responses. If we are told there is a 10% chance of failure, we internally think “we can’t fail”, whereas failure will occur roughly one time in ten.
This is a subject I’ll return to in future articles, which will explore how humans are prone to errors in making assumptions, decisions, and judgments. I’ll also be providing some useful tips on the steps we can take to improve our decision-making abilities.
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