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Business decision making, Uncertainty and Optionality

20 Jan 2015 1:59 PM - Article written by Richard Wright for Robinson Sewell Partners

Poker v Chess.

An important element of sound decision making in any area of life is access to relevant background information.

A perfect information scenario implies you have all the possible information with which to make the decision. Think of a game of chess. The pieces and moves are visible to all parties. You can act assured everything is known and understood.

Unfortunately, there are few areas of business life where this will ever be the case.

The list of unknown and mostly unpredictable information variables is long. Interest rates, inflation levels, weather, cash-flow timing, geo-political events, customer demands and preferences, your own health, local and global economic conditions, bank policies etc.

The relative importance of each will vary by business, but the point is we all face uncertainty, and we will never have all the information needed to be 100% sure we are making optimal decisions.

So instead of being like a game of chess, business decision making ends up being more like a game of poker. You see your own cards, but are unsure of those around you and must make decisions in an environment of imperfect information.

 

Embrace Optionality

The good news is that many businesses thrive regardless. They understand the limitations of being able to predict outcomes. Instead, they accept a degree of uncertainty and make sure they have options or choices in place to minimise the impact of random events and foster smarter decisions. Rather than become a hostage to uncertainty, they can often profit from it.

In financial parlance an option gives the holder the right, but not the obligation to act. They are usually only exercised when it’s financially beneficial for the holder. The payoffs are non-linear, essentially meaning you can gain proportionately more than you stand to lose. Heads I win a lot, tails I don't lose (very much).

Embracing optionality in business does not have to mean entering into financial derivative contracts. It can simply be a matter of putting yourself in a position such that you have choices to fall back on when the unexpected occurs.

 

Positioning for choice - some common examples

I'm sure most of you already do so to some degree by being part of community groups, business groups, or even sporting clubs.  These networks can be invaluable when we need information and assistance.  You never know when you will rely on them, and what doors they may open.

Another example is having access to cash on short notice to take advantage of unexpected opportunities. Famed investor Warren Buffet calls this the optionality of cash. Instead of seeing cash as a low yielding asset, he thinks of it as an option on every asset class without an expiration date. For a business owner this could mean the option to expand when a great opportunity comes your way, or the option to stay in business when things get tough.

Similarly, look to position yourself with access to alternative sources of longer term finance for situations when your regular provider is unable or unwilling to help. Don't let a single bank or institution force your hand when the unexpected occurs. At the very least it’s wise to regularly discuss various options with your advisors.


Deciding after the fact

Having a range of options to choose from means you don't need to spend much time trying to predict outcomes in advance. Instead, decisions can be made after events have transpired and you have much more information at your disposal. That can be very valuable.