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This is a presentation based on review article“From ‘Economic man’ to Behavioural Economics” by Justin Fox.The article focuses on the theme of decision-making, its approachesand ways to enhance the ability to make sound decisions. The threemethods discussed in this presentation include decision analysis,heuristics and biases and “going without your gut.” I willbriefly discuss the article, relate the material to the subjectstatistics course and finally connect it to investment banking.
The use of efficient and effective systematicapproaches in decision making, especially during the World War II,enabled governments to adopt modern techniques in warfare. Accordingto Fox, Decision analysis involves formulating a problem, listing thepossible courses of action and systematically evaluating thealternatives. The history in the field of decision analysis hasevolved from expected utility to Bayesian analysis and finallydecision analysis. The idea of expected utility involves combiningprobabilities with the gains and losses of a particular actionwhereas the Bayesian approach used available information to make thebest guess of the first probability.
Heuristics and Biases
In decision-making, the primary assumption is thathumans make decisions in an equally logical and rational manner. Besides, heuristics and biases is a vital area in decision making.However, this article tends to imply that the application ofheuristics and biases to better decision making is less clear. In myviewpoint, I believe that bad heuristics and biases can help anindividual avoid the faulty decision making that they cause.Principally, preventing faulty decision making increases the qualityof decisions we make.
“Going with your gut.”
Those for going with your gut approach argue thatin many cases using heuristics could lead to decisions that weresuperior to those achieved with decision analysis due to uncertaintyand limited time and data. Critics such as Herbert Simon suggest thatthe decision makers rarely have the time and processing power toanalyze alternatives as indicated by decision analysis. However, acombination of both approaches by Implementing decision making andheuristics while keeping in mind the weakness and strengths of eachapproach will generate a sound decision.
Statistics Course and the Article
As expounded earlier, decision analysis began withthe calculation of expected utility of different alternatives. Inthis, if all alternatives have discrete outcomes we can calculate theexpected value of each option using the formula E(x)=Ʃ[x * P(x)]where P(x) is the probability of an outcome for a particularalternative and x is the utility of the outcome for a particularchoice. Harry Markowitz added the analysis of risk and assumed thatreturn was normally distributed. Bayesian analysis was done throughthe Bayes Theorem that:
P(A1|B) = [P(A1)P(B|A1)]/[ P(A1)P(B|A1)+P(A2)P(B|A2)].
Article and Investment Banking
As an investment banker, I have to use numeroustools in decision analysis. These devices include Modern PortfolioTheory which is an offshoot of decision analysis and can be used todetermine proper discount rates which can be used to discount cashflows to determine value. It also suggests that all investors shoulddiversify to get the best return risk tradeoffs and also should holdthe market portfolio at a risk-free rate.
An investment banker should pay attention to otherapproaches to decision making as a way of avoiding bad biases and badheuristics. This limits errors such as overconfidence which leads topaying too much for an acquisition and endowment and loss avoidance.
As my presentation today has shown, there arevarious approaches to decision making. Each approach has its strengthand weakness. The best decisions are as result of a fusion of all thethree approaches while considering their strengths and weakness.
Fox, J. (2015). From “Economic Man” to Behavioral Economics.Harvard Business Review,
May 2015, 2-9.
Freed, N., Jones, S., & Bergquist, T. (2014). UnderstandingBusiness Statistics. Danvers, MA:
John Wiley & Sons