2.10 The Decision-Making Process
Decisions are not arrived at in a vacuum; they rely on
personal resources and some complex models that sometimes do not relate to the
situation. This process most of the time encompasses the specific problem faced
by the individual as well as extending to their environment. The
decision-making process can be defined as the process of choosing a particular
alternative from a number of alternatives. According to Mathews, 2005, it is an
activity that follows after a proper evaluation of all other alternatives.
However, the Normative Theory of Decision-Making tries to
explain the whole idea about the decision-making process and what economists as
well as other finance scholars think of it. This theory aims at explaining the
actual behaviour of an agent focusing on a rational decision-maker whose aim is
that of maximising utility. Applicable to this theory are three economic
conditions of risk, certainty (known possible outcomes) and uncertainty
(unknown probability distributions). Nonetheless, it is highly argued today
that people are highly rational utility maximizers who measure the likely
effect of any action on their wealth before deciding. Thanks to the normative
theory and the implementation of financial models such as rational
decision-making, risk-aversion and uncertainty, the normative theory of
decision-making has come under scrutiny.
Making a proper decision involves a trade-off between the risk
involve in the decision and the
expected return, no doubt there is a
positive shape of both the Security and Capital Market
Lines in Figures 1
and 2 encouraging the fact that investors should be motivated to take
higher risk at least by the promise of a higher expected return
although at the same time, this will greatly be determined by the investors'
behaviour and attitude towards risk.
As already discussed, most finance theories are based on a
number of assumptions of which some include the fact that investors are
rational, objective and risk-averse in their behaviour towards risk, and all
these come into play in the decision-making process. By being rational implies
the reward for an individual's decision is affected by the decisions made by
others. Therefore if everything else should remain equal, then all individuals
faced with the same situation will make the same decision. Therefore, the
optimal choice of the individual is therefore dependent on what they believe
others actions are. Cabral 2000 describes this situation as an interdependent
decision-making process. Here investors turn to view their actions as being
right or wrong depending on the action of others.
The normative decision making theory is of the opinion that
individuals try to maximise their utility. This is because, they make
economically rational decisions, they can assess outcomes and calculate the
alternative paths of these outcomes. This is usually done in a bid of choosing
the action that will yield the most preferred outcome.
However, any decision making process is dependent on the
individual's attitude and behaviour towards risk with regards to gains and
losses. Generally, attitude towards risks when it concerns gains are much more
valuable than attitude towards losses. Therefore, making a proper decision
involves a trade-off between the risks involve in the decision and the expected
return.
Nonetheless, the main assumption of the classical finance
school of thought centres on the fact that investors are risk-averse.
Risk-aversion is important because it helps us to have a clew as to how
investors confront risks and how they behave thereafter. Another assumption of
the classical financial theory is that the utility function remains constant
overtime and
between situations. As such, if faced with a problem,
individual's turn to choose the less risky alternative, at the same level of
expected return (Friedman and Sevage 1948), implying therefore that being a
risk-averse utility maximizer, investors will turn down any investment option
that present a 50/50 lose/gain risk for all initial wealth level (Rabin and
Thaler 2000).
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