How do you deal with risk while making decision?

In the previous post – Decision Making – Group & Individual perspective (Part-I), we looked at academic models which attempts to explain how decision making takes place in an organization. In this post, lets see what are risk perspective when decision makers make decisions.

Managing project involves lot of trade-offs thus instances of decision making. Some decisions involve element of risks associated with them – it could be about hiring a resource, outsourcing work, contracting a third-party, making infrastructure investment, etc. So depending on the nature of person and organization culture there are three types of risk tackling behaviors observed.

Risk Attitude

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Risk Averse (Risk-Avoiders)
Risk Neutral
Risk Takers

To understand these characteristics in simple way, let’s consider that person of each category has given choice of selecting one of the following scenarios. First one involves guaranteed pay-off and other choice can pay-off any amount from $0 to $100 e.g. in first scenario a person would certainly get $50 and in other case he may or may not receive the amount (i.e. either $100 or nothing, like flipping a coin). Considering both scenarios, expected pay-off is $50. Let’s look at the risk-appetite for each category.

: Pay-off Utility and Risk Attitude

Risk Averse (Risk Avoiders)

Risk Averse people tend to select option that involves lesser risk thus favoring certainty or familiarity. So in above case, Risk Averse person will accept certain pay-off (that gives him/her $50) but he/she will not bet on other option with the fear of receiving nothing.

Risk Neutral

This category of people is indifferent between the pay-off being received from either case –whether it is assured $ 50 or the bet to receive $0 or $100.

Risk Seeker

This set of people can take a risk of betting on the option that can give them return on the risk taken e.g. if there he/she is given an option to receive assured $50 or to pay a bet to receive either $0 or $100 (with each probability of 50%) then he would like to take the risk of potentially not receiving any money and will play the bet.

Challenges for senior management

Higher management has to difficult task of balancing risk-strategy in their portfolio. One end too cautious approach (which kills creativity or plays safe but costly manner) and at the other end too risky bets (which can lead to disaster). Let’s look at another important aspect that portfolio managers need to keep in mind – it is called escalation of commitment.

Escalation of Commitment:

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“Continuing to support a failing course of action” is escalation of commitment.

Typically in the scenario of ‘escalation of commitment’, decision maker has committed some resources (money, equipment, personnel, etc.) with the hope of receiving returns on the investment and even when he/she realize that the decision has disappointing results, he/she tends to support or hold on to that decision in the hope of better results. There can be various reasons why the characteristic of escalation of commitment is exhibited.

Reasons for escalation of commitment

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A research report on Escalation of Commitment by Theresa F. Kelly and Katherine L. Milkman attempts to explain why decision makers tend to escalate commitment. Here is the list

Self-Justification Theory
Loss Aversion
Confirmation Bias
Impression Management

Self-Justification Theory

According to this explanation, decision makers feel personally responsible for the investment made. The sense of potential failure drives him/her to justify original decision also they also exhibit selective distortion (i.e. any negative feedback is ignored & positive events are highlighted).

Loss Aversion

This explanation of escalation of commitment highlights how the threat of future loss (or loss of prospective rewards) drives decision makers to continue to support their original decision i.e. the feeling of pain caused by loss of $500 is far more than feeling of happiness by gaining $500. In short, decision makers forget to apply STOP LOSS parameters and continue to make inexpedient decisions to avoid these losses.

Conformation Bias

This kind of behavior is again further/refined case of selective distortion wherein decision makers reduce the disagreement arising out of positive self-perceptions and the evidence that past investments are performing far below expectations. Thus if decision makers have chosen to commit resources or invest for a given option, they are more likely to highlight and show-case the cues/evident that support their decision and ignore/ in-signify negative evident or cues of underperformance. It is the case wherein the confirmation bias drives decision makers to make inexpedient decisions.

Impression Management

The explanation termed as ‘Impression management’ for explanations of escalation highlights the psychology behind sticking to original decision. The decision makers want to retain their impression as ‘consistent decision maker’ as against flip-flopper by not-moving-away from original decision. Such impression management technique is used to avoid apparent signaling signs of weakness or lack of confidence. So even if decision maker is of the view to stop-supporting his original decision, he/she may still stick to the original choice to maintain impression and remain consistent.

Let’s look at the factors that can help avoid escalation of commitment.

How to avoid escalation of commitment

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According to a research paper, there are two main drivers for overdrawn optimism.

Perceived Control – perceived illusion of control over risk-dependent-results
Track Record – Decision makers known for their ability to manage risky projects in the past

#	What can be done	Avoids
1	Proactively search for disconfirming info about a chosen option	Conformation bias
2	Re-draw losses as gains to prevent risk-seeking behavior	Loss aversion
3	Structure/organizational incentives so that decision makers will not feel being punished for inconsistency	Impression management
4	Hand off decisions about whether to commit more resources to an investment to new/different decision makers (concurrence)	Personal responsibility
5	– Generate report project status and problems involving & describing active decision situation – Ensure clear evaluation criterion and provide qualitative feedback	Perception threshold
6	Clearly outlining project termination can be an option	Selective perception
7	Being cautious of considering expended resources when making decisions	Sunk costs
8	Frequently remind decision makers of the goals of the investment	Proximity to completion