When was the last time you thought about risk, risk management and your business? Minutes ago, hours ago, days ago, months ago? When was the last time you really thought about decision making and risk management for your feed and grain business? We are usually acutely aware of many of the primary risks in our business, and often even the daily minimal risks. You probably think about price volatility and market risk and weather; insurance and forward contracts and hedging; grain quality and feed spoilage; health and safety; and maybe even hot coffee and paper cuts. But what about the actual manner in which you analyze a situation and make a decision? Are you doing a good job understanding your thoughts and your decision-making process? Ever wonder if your head is really working like you think it is? We usually assume that everyone makes rational decisions. But do they really? In this column, we explore how people make decisions and in particular, we relate this to risk management. We discuss some of the models of decision making and weaknesses in our decision-making process all with the goal of improvement for you and your business through this better awareness.
Making decisions and risk management
In the past we have discussed methods to reduce and mitigate risk such as avoiding risk; retaining risk; transferring risk; sharing risk; and reducing risk. It is also useful to approach risk management with a strategic risk management process that can include such steps as determining the financial health of your feed and grain business; determining your risk preferences as manager and perhaps those of your key staff; establishing goals; identifying risks; determining sources of risk; measuring the risk; identifying management alternatives (formulating strategies to limit risk); estimating likelihoods; carrying out tactics to implement your strategies; and monitoring your efforts in risk reduction. All of these steps include important managerial decisions.
We generally approach these decisions in an assumed “rational choice manner,” a bit of “economic speak” if you will — meaning that people behave in a manner assuming that they do actually have preferences which they act on; they act with full information; and they make decisions, or choices, in order to maximize their utility or the value which they receive from their choices. (This can also be thought of as “well-being” or “usefulness.”) We, the authors, are indeed economists, and we have spent years thinking like economists and trying to teach others to think like economists. However, might there sometimes be social, cognitive, and/or emotional factors that influence decision making that may make decisions appear irrational to some? Rather than thinking about only economics driving decision making, let’s consider economics, psychology and even neuroscience as impacting decisions — a neuroeconomics if you will. Now, we are not going to have you run out and get an MRI of your brain or your co-worker’s brain, but it can be useful to consider what activity might be taking place in your mind as you are engaged in certain tasks and decisions. We recognize that many people do not naturally think like economists; that is some people have to work to overcome the way they might naturally think in order to think and behave like an economist.
Automatic and controlled decision systems
In our strategic risk management process, it is interesting to consider our short-term and long-term thought processes and our behavior in this decision making. We might think of the short term as a possible automatic process influenced by passions and impulses and temptations. Some researchers refer to the short term as a “hot” state in some situations, for example if you are hungry, angry, sad, etc. Your automatic system operates quickly and automatically with little thought, effort or voluntary control. Your automatic system can come to a conclusion without you even being aware of how it was decided. The long term can be a more self-controlled system of planning and deliberative actions in which we can (try to) be immune to temptations. The long term might be considered a “cold” state because you are not hungry, angry, sad, etc. Your control system is slower, more analytical and rational. Your control system constructs thoughts in an orderly series of steps and requires attention. It is disrupted when attention is drawn away. Your control system does have some ability to change the way your automatic system works by programming the normal automatic functions of memory and attention. However, attention requires effort, and attention is a limited resource to people. We only have so much of it at any time. And, if we use too much of our attention resource endowment on one thing, then we may miss something or make an error with a different issue during the same time period.
Our automatic and control systems interact. As implied by its name, our automatic system is automatically active while our control system is normally in a comfortable low-effort mode — engaging only some of its capacity at times. Our automatic system generates suggestions of impressions, feelings and intuitions for our control system. Our automatic system does not need data or information to make decisions. If our control system endorses the automatic input, then these impressions turn into beliefs and our impulses turn into actions — that is we make a decision. Our control system does need information or data to make decisions. Economists assume that our control system makes all of our decisions. A psychologist assumes that our automatic system makes all of the decisions, and we use our control system to come up with logical reasons for what we did.
Errors in decision making
Even though our automatic and control systems are working, errors can occur in our decision making for a number of reasons. We are generally not able to turn off our automatic system; and our automatic system can make errors in our intuitive thoughts. Our system may go too fast — ever try to count all of the f’s or t’s in a sentence? Our control system may not see errors, so sometimes we may not be able to avoid biases, and our control system can be too slow to check all of our thoughts. Knowing this is important because we can use this information to help us recognize situations in which mistakes are likely. We can try harder to avoid significant mistakes when the stakes are higher. Let’s explore some short-term and long-term errors for which to be on the lookout.
❚ Discounting errors
The first error to watch for in your risk management decision making is that of hyperbolic discounting, which means you may overstate the discounting between time periods and you may not think of it as constant. For example, one may think that the discount rate between now and later is huge but that the discount rate between later and a little later is smaller. The discount rate is usually constant for businesses but not for individuals. If our automatic system is controlling us too much, we may pay a lot or too much to immediate gratification. For example, maybe you want to acquire a new cell phone or you want to redecorate the office. You want these now and might be willing to pay $X per month to have these. You need to ask — is the discount rate and cost appropriate for the immediate gratification?
If we do not plan at all, then our automatic system is driving us and we have completely discounted the future. For example, maybe you do not plan appropriate health or safety features. This discounts the importance of health in the future. You might relate to an athletic example of this — maybe you played football or another sport in high school or college. When you are young, do you give enough weight to being able to walk or function well in the future with possibly significant sports injuries versus playing and experiencing short-term gratification or glory in your sport? To help avoid hyperbolic discounting, you must look ahead and plan and weigh your outcomes appropriately.
We usually think of diversification as beneficial in risk management, but it is not beneficial if it does not reduce risk and is costly; or if it reduces risk but costs too much relative to the benefit of the risk reduction. Diversification in some situations may reduce risk and increase profits. However, often diversification reduces risk and also reduces profit. There is a trade-off here. The issue you face in your feed and grain business is that you must determine if the risk reduction is worth the reduction in profits. Make sure the diversification benefits are worth the costs and if not, then control the decision and reduce the diversification. Avoid diversification that reduces profit and provides no benefit. Our tendency is to avoid losing options even if they are bad options because we like diversification, even when it may be pointless and costly.
Most people have a diversification bias — that is we avoid focus, we like having options and do not like losing options, even poor ones. Experiments show that people struggle to let a choice option disappear even if they know there is no advantage with that option. Our diversification bias causes us to avoid focusing our business even when it is the correct choice!
Experiments also show that people plan more future variety than they will actually want. And, irrational variety causes people to make choices with a lower probability of outcome just because of the variety. For example, on a roulette wheel where 60% of the slots are red and 40% of the slots are black, why would a person ever choose black on either any single spin or on any spin within a series of spins if the goal is to maximize the payoff? In our example, they might choose black just because it gives variety to their choice set. We struggle to let options go and to not have variety, and we avoid focusing on one choice even when it is the only correct choice!
Another error in our decision making can be caused when we choose by comparing with a nearby reference point — this is called anchoring. This happens a lot in purchases. When choices are available, there is a tendency to anchor and compare to a nearby option. Anchoring can lead to excessive influence of the nearby comparison. The presence of a comparably worse nearby option makes another option seem better. You can see this in magazine and newspaper subscriptions.
If you are given three options of a digital-only subscription, print-only subscription, or a digital and print subscription where the digital-only subscription is the cheapest option and the print-only subscription and the digital and print subscription are the same price, then the majority and largest percentage of purchasers will select the digital and print subscription. However, if only given the options of a digital-only subscription or a digital and print subscription where the digital-only subscription is the cheapest option, then the majority and largest percentage of purchasers will select the digital-only subscription. We also see this when a high-priced object has a sale price — look what it cost before the sale.
You can be aware of anchoring when you make purchase decisions for your business. But, you can also use anchoring in your own sales for your feed and grain business. You can control the decision environment by setting the anchor and by providing only a couple or a few options from which to choose. It is too difficult for people to compare a larger number of items (see discussion of hyperchoice below), so providing just a couple options works best to influence the purchase of the one you want to sell.
We typically think of choice or options as being good. But, too many choices — hyperchoice — can actually be negative in our decision making because it makes decisions less likely. Too many choices can make decisions difficult and may lead to actually doing nothing. Simplicity or limited choice can be better. For example, when enrolling new freshmen for the fall semester, they struggle to make a decision and pick a class time when given many time options for a single course; however, when they are given only two or three of the many choices, they much more easily and quickly decide. When given choices for an extra credit assignment, a higher percentage of students will complete an extra credit assignment when given only a small number of assignment choices, like six, rather than being given a much larger number of choices, like 30. Sometimes controlling the decision environment means eliminating options.
❚ Loss aversion and endowments
People are more motivated to avoid a loss than they are to acquire a similar gain. And, once people own something, this ownership creates satisfaction for them. It is more painful to lose something that we once had than it is important to acquire something that we do not own. A loss hurts more than a gain feels good. If a choice is framed as a loss rather than as a gain, different decisions will likely be made even though the data are the same.
Risk is the chance of loss. Consider an old piece of equipment in your business. You already own it. Think about what price you would sell it for; now think about at what price you would buy it if you were to purchase it. They are probably not the same value. You may also not consider the equipment that “great,” and you may not purchase it if that were an option, but you possibly don’t want to get rid of it or have it destroyed.
As another example, consider the situation where you are examining processes, procedures and requirements of your grain storage to prevent spoilage. You are expecting to lose 6,000 bushels to spoilage but you have two options to approach this issue. If you choose option A, then 2,000 bushels will be saved from spoiling; if you choose option B, then there is a one-third chance that all 6,000 bushels will be saved from spoiling and a two-thirds chance that zero bushels will be saved from spoiling. Which do you choose? How about if option A is now that 4,000 bushels will spoil and option B is that there is a one-third chance that none will spoil and a two/thirds chance that all 6,000 bushels will spoil? Which do you choose? Did you pick option A the first time and option B the second time, as most people do? Well, the expected outcomes are actually the same for both questions. In the first choice there is a one-third chance that no bushels will spoil and a two-thirds chance that all bushels will spoil which is the same as in the second choice where there is a one-third chance that 6,000 will be saved from spoilage and a two-thirds chance that no bushels will be saved from spoilage. Only the framing of the situation changed. When the same choice is framed as a loss rather than as a gain, people make different decisions. Be aware of this loss aversion and remember that people have a tendency to take great risks to avoid a loss.
❚ Status quo bias
We will sometimes avoid action and avoid change; this is called our “status quo bias.” We are biased to keep things the way they are — even if we did not originally make the choices that led to the status quo. And, we are biased to avoid risk generated by change even when the risks after the change are less than from making no change. Knowing that we may be influenced by status quo bias can help us control or design our decision environment and use it to our own advantage. To do this we need to make something a habit, own it, and fear its loss. Once we have created the habit, the habit becomes the status quo.
When you own something or identify with something, then you get satisfaction from it and are attached to it. And, temptations that put it at risk can be framed as a potential loss and you will fear the loss. One example in your feed and grain business could be your safety program and the number of days without an injury. You might make various safety practices and procedures a habit; maybe you need to make some changes to implement additional or new safety practices. You own and want to have successful safety and no injuries for a significant amount of time. You do not want to lose the safety record by not following safety practices and having an injury occur.
Decision making can be challenging, and decisions relating to risk management are often crucial in the feed and grain business. We have risk associated with many decisions, and some decisions have many outcomes, some good and others not so good, with different likelihoods. We cannot eliminate or reduce all risk. However, we can make efforts to assess and understand our risks, and plan for risks and uncertain events. But, it is not enough to have risk management plans and processes in place. We can improve our risk management by understanding our decision making and by being aware of the pitfalls, challenges, and biases in our thinking. Better decision making in a risky environment can be valuable to everyone, and better awareness of our decision making can lead to improvement.