Five guidelines for effective decision-making in an uncertain world

While we are always operating in uncertain times when making investment decisions, some periods, like 2022, are much more daunting than others. This article shares five essential guidelines to help investment committees manage uncertainty and limit negative influences in the decision-making process.

Understanding uncertainty

In the book, Thinking in Bets by Annie Duke, she addresses the topic of uncertainty. Duke has a PhD in psychology and was a professional poker player and past world poker champion. Drawing on her poker-playing experience, she highlights how good poker players and good decision-makers have comfort with the world being uncertain. Instead of focusing on trying to be sure about a decision, they try to determine how unsure they are, which Duke suggests can make for better decisions.

Risk and uncertainty go together. The international risk management consultant, Dr. David Hillson, describes the relationship as, “All risks are uncertain, but not all uncertainties are risks.” For example, if the weather forecast suggests the potential for rain, it implies an uncertainty rather than a risk, which could be addressed by simply bringing an umbrella.

Hillson suggests risk is uncertainty that matters. This naturally leads to the question: how does one know what matters? The key is to understand both the probability of the risk occurring and how material the consequences could be if things do not go as expected. If an event has a high probability of occurring and the risk is material, then it would certainly matter and need to be addressed.

Managing uncertainty

So, what can be done to manage uncertainty? The first guideline is to recognize uncertainty exists, while the other guidelines layout a clear approach for effectively steering through it.  

Guideline 1: Decisions are best made with everyone’s eyes open.

This is crucial and depends on acknowledging the unpredictable nature of decisions for which there are risks that can – and can’t – be controlled. It is also necessary to assess the level and likelihood of the risk. For example, if a risk associated with an investment portfolio is expected to have a minimal impact and low probability of occurring, then a committee may decide it is an acceptable risk to bear. However, for risks identified as material and with a higher probability of occurring, a committee would want to mitigate the risk, such as by improving portfolio diversification. 

Guideline 2: Deconstruct the problem into more manageable elements.

This guideline draws on the idea of the “uncertainty onion” by breaking down a problem into smaller, more manageable elements. Like peeling back an onion, assessing the various layers of a situation can provide useful insights that may not have been evident on the surface.

One such element is framing, which recognizes there are distinct types of uncertainty that are sometimes labelled the same. For example, limited knowledge could be due to the unpredictability of an outcome, such as the impact of equity market volatility. Alternatively, limited knowledge could be due to a committee having little information on a new topic, such as the role of private markets. The response would be different for each one.

Another layer of the onion is to appreciate the various individuals, groups and organizations connected to the decision and identify the stakeholders who hold influence over the decision, those with the expertise that can support it and those who will be impacted by it.

It is also important to distinguish between fact and assumption. For example, an assumption for an annualized 7% return over the long term is simply the best estimate of the expected return and not necessarily the return that will be achieved.

Guideline 3: Realize the benefits and limitation of models.

Managing uncertainty can include appreciating the advantages and constraints of models that are used to help make decisions. The British statistician, George Box, points out:

“All models are wrong; some models are useful.”

One of the most useful benefits of models is they can foster better understanding. In the construction of a new building, a small-scale architectural model serves as a visual representation of the final building design. Providing a clearer picture and overall feel of the project can help identify and rectify potential design flaws, ultimately saving material costs during the actual construction phase.

Statistical models are frequently used to review investors’ long-term policy asset mix. The role of these models is to foster a better understanding of the relative merits of different potential asset mixes before committing any real money to them. While these types of statistical models are helpful in aggregating much complex information to assist in decision-making, they are only tools and provide no guarantee of the actual outcome.

Guideline 4: Do not be fooled by behavioural biases.

When making decisions, it is important to be aware of behavioural biases that can subconsciously influence our choices. These biases often pose challenges for investment committees.

Common decision-making biases

In their book, Decisive, Chip and Dan Heath refer to four of these common biases as the “Four Villains,” shedding light on how they can influence decisions and ways to minimize their impact.

• Narrow framing: This bias limits our perspective by focusing our attention on a specific area, like a spotlight illuminating one part of a stage while leaving everything else in the dark. Narrow framing can cause us to overlook potential options and important considerations. To overcome this bias, it’s important to widen our outlook, moving the spotlight to different areas of the stage to uncover new ideas and possibilities.

• Confirmation bias: This bias leads us to seek and favour information that confirms our existing beliefs. It can result in gathering self-serving information underestimating the risks associated with the decision. To combat confirmation bias, it’s helpful to reality test our assumptions. One way to do this is by having someone play the role of devil’s advocate, challenging our ideas and providing constructive criticism before finalizing the decision.

• Short-term emotion: This bias refers to the influence of immediate emotions on decision-making. It can lead us to make impulsive choices without fully considering the long-term consequences. To mitigate the impact of short-term emotion, it can be beneficial to conceptualize the implications of our decisions in a future timeframe. By imagining how we might feel about the decision six months down the line, we can reduce the sway of immediate emotions.

• Overconfidence: This bias involves placing too much confidence in the likely future outcome of our decisions. We tend to believe our judgements and predictions are more accurate than they are. To address overconfidence, acknowledge the inherent uncertainty in decision-making. Be prepared to accept that you may be wrong and understand the potential downside risks associated with your choices.  

Being mindful of these biases and implementing strategies to avoid them can aid in making more informed and rational decisions.

Guideline 5: Bring all involved along.

The final guideline to manage uncertainty emphasizes the importance of involving all stakeholders in the decision-making process. When a new idea is presented at a meeting, it is common to not immediately welcome the idea and instead resist what is being proposed. New ideas are often met with push back no matter how well the information is presented.

It is helpful to identify when resistance is present and to allow stakeholders to express their concerns, and by doing so build trust with the various stakeholders. Communication is also integral to bring about change. Making sure there is discussion at each step of the review can help avoid a situation where, at end of the review process, it is discovered key decision-makers got lost along the way.

How to be a more effective decision-maker

As daunting as it can sometimes be, it is necessary to make investment decisions in uncertain times. Following a disciplined process and being aware of the influences that can derail it can help you be a more effective decision-maker.

Thriving in the face of the unknown

• Be comfortable with the uncertainty associated with investing.

• Prioritize the risks that are most relevant to your desired goals.

• Recognize and accept the unpredictable nature of decisions.

• Deconstruct complex decisions into manageable elements for easier analysis.

• Use models as tools to gain a better understanding of available options while being aware that they do not guarantee an actual outcome.

• Be mindful of behavioural biases that can impact decision-making and take steps to manage their influence.

• Foster effective communication to facilitate change and ensure informed decision-making.

As an investment decision-maker, navigating uncertainty with a steady hand, disciplined strategies, open communication and by managing biases can empower you to make informed choices and thrive amidst complexity.