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1st Draft,RESEARCH PROPOSAL

:
Decision Making Process (DMP)
Under Risk and Uncertainty
supporting Business Strategy

Research Part I: Decision Making – Business Strategy
(MBA Ohio University – 2006/2009)

Part I.1: Prescriptive Theory – Managerial Economics

Part I.2: Descriptive Theory – Behavioral Economics/Finance

Part I.3: Strategic Management

Research Part II: Strategy Dynamics (PhD- at
Chicago University ??? – 2009/2012)

by

Ney M. Vasconcellos Jr.

Purchasing & Logistics Director Mercosul

Email: devasconcellos@lycos.com

October 2007
DMP and Business Strategy Overview
Most of managers make many decisions that involve questions of resource
allocation within the organization in the short and long run. In the short
run, managers may be interested in estimating demand and cost
relationships to make decisions about product price and the quantity of
output to produce. The areas of microeconomics dealing with demand
theory and with the theory of cost and production for sure are useful in
making decisions on such matters. Macro economic theory also plays an
important role on decision making when managers attempts to forecast
future demand based on forces influencing the overall economy.

In the long run, Business Strategies/Decisions must be made about
expanding or contracting production and distribution facilities, developing
and marketing new products, and possibly acquiring other firms. Another
important issue we must consider is that some incumbent firms have been
observed to face challenges in maintaining impactful innovative streams and
responding to technological changes over time. Many companies have one
approach which has been actively pursued to address these challenges over
the past decades is the acquisition of other companies to supplement
internal innovation efforts in rapidly changing high-technology industries.
In this case, certain risks may arise when using this strategy, which is to
buy novel products, technologies, and capabilities.

Basically, these decisions require the organization to make capital
expenditures, that is, expenditures made in the current period that are
expected to yield returns in the future periods. For example, if a manager
of an automotive manufacturing plant note, that their problem is the use of
technologically inefficient equipment, two possible solutions are (1) updating
and replacing the plant’s equipment, or (2) building a completely new plant.
The choice between these alternatives depends on the relative costs and
benefits, as well as other organizational and societal constraints (as
culture, government regulations, etc.) that may make one alternative more
preferable than the other.

Economists have developed prescriptive (normative) theories to support
decision making process. In this case, there are many theories and one that
is used the most is The Expected Utility Theory (EU) that defines the
conditions of perfect utility-maximizing rationality in a world in which the
probability distributions of all relevant variables can be provided by the
decision makers, in other words, a certain world. (It might be compared
with a theory of ideal gases or of frictionless bodies sliding down inclined
planes in a vacuum – ideal state).

What distinguishes the descriptive (behavioral) research on decision
making from the prescriptive approaches derived from EU theory is the
attention that the former gives to the human rationality limits. These
limits are imposed by the complexity of the world in which we live, the
incompleteness and inadequacy of human knowledge, the inconsistencies of
individual preference and belief, the conflicts of value among people and
groups of people, and the inadequacy of the computations we can carry out.

MY RESEARCH
I have decided – I mean, I have allowed myself to be seduced by the
decision making process theory to support business strategy– that includes
rational and behavioral influence – to engage in a research for my Master’s
Degree in Business Administration at Ohio University.

Lately, I had the opportunity to discuss with several remarkable
researchers and to read some research material about Behavioral
Finance/Economics and have also taken very interesting courses related to
Business Strategy - Management Science/Managerial Economics and
Quantitative Methods. I must confess that they are all fascinating fields,
which I intend to research, focusing on important issues for our society
and human behavior.

In my previous research (from 1995 to 1997) – Quantitative Approach – at
Systems Engineering Department, Kyoto University (Japan), I have
developed a probabilistic model to evaluate the total cost of Systems’
Active Life Cycle (which includes systems acquisition, installation,
operation, and retirement). This research was published by the
International Journal of Operation Research, under the title Life Cycle
Model for Acquisition of Automated Systems – Volume 37 – Number 9 –
June 15th, 1999 – pages 2077-2092. I find this quantitative method/
research very interesting, because besides having a theoretical background
it can be used in our daily business activities.

In this new research at Ohio University, my main goal is to contribute to
the field of Decision Making Process (DMP) – Under Risk and
Uncertainty, to support Business Strategy. I am very much inclined to
take this research in a specific direction, which is the study of Rational
Decision Making and Behavioral Economics/Finance to support Business
Strategy.

At this point, I am considering three options to write my thesis:

Option (1): Take Benteler Automotive Corporation and formulate a
Worldwide Strategy Business Model/Case for the next 5-10 years –
considering all Benteler’s five regions: Northern Europe, Southern Europe,
North America Operations, Mercosul, and Asia. This Real Model/Case would
be a complete application of rational and behavioral decision making in the
process of formulating corporate business strategy. Main points to be
considered should be (choose one or all Benteler’s business units: chassi,
structures, exhaust systems and engine applications):

- Technology trend in the automotive market has become one of the most
important issues in the last decades. For example, electronics are becoming
a very important component in the automobile market. Its application varies
for each country/region, and we must define the right time to start its
application, and where to use them.

- Understand new entrants and the current competitors. What are they
doing? Are they investing in a particular business? Are they planning and/or
acquiring new businesses? What directions are they taking? Be global or
concentrate in a particular business or region? Are they willing to be Tier 1,
Tier 2, or/and Tier 3? Study the latest Tier one’s joint ventures. What is
behind it ?

- What kind of relationship with suppliers is desired? Have a long term
relationship with suppliers as the Japanese OEMs do, or as the American
OEMs do? Have long term agreements? Have a cooperation agreement?
Have a hybrid approach? Work with low cost countries (LCC)? Make or buy
decision making is becoming an important issue. Are we willing to share our
technology with our suppliers? Do we have a choice? How long can we keep
our technology just for ourselves and few others?

- Customer relationship must be well defined. Work with OEMs alone or
also supply to Tier one customers? What would be the right split? Does this
choice minimize business risk? Price sensitive analysis and policy must also
be well performed and defined, respectively. Are we willing to accept lower
margins and take higher risks with projects with lower volumes than
initially planed? Or concentrate in keeping our current profit level? Or may
be try to improve the profit level, with the penalty of loosing business? Can
we do it without loosing business with more value engineering and value
analysis?

- Company marketing is needed? If yes, how to do it?

- What kind of supplier are we willing to be? Take more responsibility on
design, or make to print? What is the market trend? What are our
customers requesting? What would be more profitable and lower risk?

- New plants, investments, projects, etc. – what king of tool we must use to
make the right decisions on those issues?

- Laws and regulation are also important players in our business
environment. Each country has its own laws and regulations, so it is
important to understand them. That is what means being a global company.

- Cultural values/customs/history/economy system for the countries we
are willing to have business.

- When making the right decision, we must prepare an alternative risk
analysis and understand well the consequences of each decision (not
necessarily a pure rational decision). Rational and behavioral analyses are
the right way to go.

- This research work is considering all Benteler’s business units as
described above. Decisions made for a particular business unit will affect
the others. This interaction, among business units, must be also
investigated as part of the Strategy Model/Case.

Option (2) Work on a research that will combine the rational and
emotional decision making process to support business strategy. The idea
would be to prepare a complete general business strategy guide to support
the business strategist, and at the same time, try to find a solution for
some topics as: decision making over time (discounting); aggregation, i.e.,
individual impact x the market; and limited/bounded rationality.

Option (3) Try to combine both (1) and (2). In this case, I will work
heavily on the theoretical part of prescriptive and descriptive theories, and
prepare a complete strategy business case for Benteler Automotive.
An Introduction to Decision Making Process
(DMP)
Today, investors, managers, entrepreneurs, scientists, engineers, lawyers,
doctors, professors, economists, philosophers, politicians, and others are
the ones responsible for the development and the course of society and its
economic and governmental organizations. Their job is pretty much related
to making decisions, under risk and uncertainty, and solving problems
related to others/society.

It is very important that the decisions, that they have to make in such
uncertain environment, are made according to society needs, and thinking
of the long term perspective. To perform effectively, the decision maker
must be well prepared to understand the whole DMP, and I mean the
variables related to each phase of the process of making decision, such as:

(i) rational decision making/management science/managerial economics:
decision making based on the scientific method;

(ii) behavioral decision making (behavioral economics): decision making
based on human behavior, i.e., decision maker own instinct, intuition, fears,
cognitive biases (are distortions in the way humans perceive reality), their
rational limitation (bounded rationality), etc.

Each decision is extremely important for the well-being of society, since
they are related to several problems at the national level and at the level
of business organizations (e.g., new product development, choice of
investments, merger and acquisitions, etc.), and at the level of our
individual lives (e.g., choosing a career or a school, buying a house, get
married, have children, deciding what kind of investment, etc.).

In areas as psychology, economics, mathematical statistics, operations
research, political science, and cognitive science, major research gains have
been achieved, during the last decades, in understanding decision making.
The progress already achieved is substantial, but we still need new
advances that will contribute substantially to the world capacity for dealing
intelligently (not necessarily being rational) in the process of making
decision.
Strategy Management
I do believe that business executives would do better if they adjusted
their thinking about the context of strategic decisions, rather than trying
to find for ready to use formulas. That is a very difficult task.
First of all, they should understand that the business world is constantly
under risk and uncertainty. We all know that people in general want the
world to make sense, to be predictable, and to follow clear rules of cause
and effect. Managers are not different, when dealing in their business
world. They want to believe that their business world is also predictable,
that specific decision or action will lead to a certain outcome. Yet strategic
choice is inevitably an exercise in decision making under uncertainty.
Another source of uncertainty involves customers: will they embrace or
reject a new product or service? Even if a company accurately anticipates
what customers will do, it has to contend with the unpredictable actions of
new and old competitors.
A third source of uncertainty comes from technological change. Whereas
some industries are relatively stable, with products that don’t change much,
and customer demand that remains fairly steady, others change rapidly and
in unpredictable ways. A final source of uncertainty concerns internal
capabilities. Managers can’t tell exactly how a company—with its particular
people, skills, and experiences—will respond to a new course of action. Our
best efforts to isolate and understand the inner workings of organizations
will be moderately successful at best. Combining these factors becomes
clear why strategy involves decisions made under uncertainty.

A strategy is a long term plan of action designed to achieve a particular
goal, most often "winning". Strategy is differentiated from tactics or
immediate actions with resources at hand by its nature of being extensively
premeditated. Strategies are used to make the problem or problems easier
to solve, and also for us to understand it more.

The strategy word derives from the Greek word stratēgos, which derives
from two words: stratos (army) and ago (ancient Greek for leading).
Stratēgos referred to a 'military commander' during the age of Athenian
Democracy.
Contents

1 Interpretation
2 Tactics
2.2Military usage
2.2 Other Usages
3 Strategic Management

1. Interpretation

Strategy is dynamic/adaptable by nature rather than rigid set of rational
instructions. The simplest explanation of this is the analogy of a sports
scenario. If a football team were to organize a plan in which the ball is
passed in a particular sequence between specifically positioned players,
their success is dependent on each of those players both being present at
the exact location, and remembering exactly when, from whom and to whom
the ball is to be passed; moreover that no interruption to the sequence
occurs. By comparison, if the team were to simplify this plan to a strategy
where the ball is passed in the pattern alone, between any of the team, and
at any area on the field, then their vulnerability to variables is greatly
reduced, and the opportunity to operate in that manner occurs far more
often. This manner is a strategy.

2. Tactic

Tactic (<greek taktiké or téchne = art of troops maneuver) is any
component element of a strategy, with the objective of achieving any goal
for a corporation, for example.
Strategy searches for a more broad vision, and tactic searches for the
micro part of the whole process.
Tactic worries with how a task is performed, and strategy with what must
be done.

2.1 Military usage

The terms tactics and strategy are often confused: tactics are the actual
means used to gain a goal, while strategy is the overall plan, which may
involve complex patterns of individual tactics. The United States
Department of Defense Dictionary of Military Terms defines the tactical
level as

...The level of war at which battles and engagements are planned and
executed to accomplish military objectives assigned to tactical units or
task forces. Activities at this level focus on the ordered arrangement and
maneuver of combat elements in relation to each other and to the enemy to
achieve combat objectives.

If, for example, the overall goal is to win a war against another country,
one strategy might be to undermine the other nation's ability to wage war
by preemptively annihilating their military forces. The tactics involved
might describe specific actions taken in a specific location, like surprise
attacks on military facilities, missile attacks on offensive weapon
stockpiles, and the specific techniques involved in accomplishing such
objectives.

2.2 Other usages

Referring to non-military uses of the term, in his work The Practice of
Everyday Life, French scholar Michel de Certeau suggests strategy and
tactics are alike and they both operate in space and time. However, unlike
strategy, which inherently creates its own autonomous space, “a tactic is a
calculated action determined by the absence of a proper locus. … The space
of a tactic is the space of the other”. A tactic is deployed “on and with a
terrain imposed on it and organized by the law of a foreign power.” One who
deploys a tactic “must vigilantly make use of the cracks that particular
conjunctions open in the surveillance of the proprietary powers. It creates
surprises in them”. Tactics, then, are isolated actions or events that take
advantage of opportunities offered by the gaps within a given strategic
system, although the tactician never holds onto these advantages. Tactics
cut across a strategic field, exploiting gaps in it to generate novel and
inventive outcomes. Tactics are usually used to spoil the running context.

3. Strategic management
Strategic management is the art and science of formulating, implementing
and evaluating cross-functional decisions that will enable an organization to
achieve its objectives. It is the process of specifying the organization's
objectives, developing policies and plans to achieve these objectives, and
allocating resources to implement the policies and plans to achieve the
organization's objectives. Strategic management, therefore, combines the
activities of the various functional areas of a business to achieve
organizational objectives. It is the highest level of managerial activity,
usually formulated by the Board of directors and performed by the
organization's Chief Executive Officer (CEO) and executive team.
RESEARCH PART I.1: Prescriptive Theory –
Managerial Economics (MBA at Ohio
University)
Overview

A Rational Decision Making Model is a model which emerges from
Organizational Behavior. The process is one that is logical and follows the
orderly path from problem identification through solution. A Rational
Decision Making Model can consist of seven step model for making rational
and logical reasons:

1. Define the problem: The very first step which is normally overlooked
by the top level management is defining the exact problem. Although we
think that the problem identification is obvious, many times it is not. The
rational decision making model is a group-based decision making process. If
the problem is not identified properly then we may face a problem as each
and every member of the group might have a different definition of the
problem. Hence, it is very important that the definition of the problem is
the same among all group members. Only then it is possible for the group
members to find alternative sources or problem solving in an effective
manner.

2. Generate all possible solutions: The next step in the rational decision
making process is, after defining the exact problem, to generate all the
possible solutions of the problem. This activity is to be done in groups, as
different people may have different ideas or alternatives to the problem.
If you are not able to explore more and more solutions to then there is a
chance that you might not arrive at an optimal or a rational decision. For
exploring the alternatives it is necessary to gather information. To gather
this information the use of technology is a must.

3. Generate objective assessment criteria: After going thoroughly
through the process of defining the problem, exploring for all the possible
alternatives for that problem and gathering information the third step says
evaluate the information and the possible options to anticipate the
consequences of each and every possible alternative that is thought of. At
this point of time we have to also think over for optional criteria on which
we will measure the success or failure of our decision taken.
4. Choose the best solution which we have already generated: Based on
the criteria of assessment and the analysis done in step 3 choose the best
solution which we have generated. Once we go through the above steps
thoroughly, implementing the fourth step is easy job. These four steps
form the core of the Rational Decision Making Model.

5. Implement the chosen decision

6. Evaluate the “success” of the chosen alternative

7. Modify the decisions and actions taken based on the evaluation of
step 6.
The Research – Rational Decision Making (MBA-
Master’s Degree at Ohio University- USA)
Contents:

1 Introduction

2 Rational DM topics

3 Critical conclusions of Management Science

4 My Comments
5 References

1. Introduction
Management science, or MS, is the discipline of using a mathematical
model, and other analytical methods, to help make better business
management decisions. The field is also known as Operations research (OR)
in the United States or Operational Research in the United Kingdom.

Some of the fields that are englobed within Management Science include:
decision analysis, optimization, simulation, forecasting, game theory,
network/transportation forecasting models, mathematical modeling, data
mining, probability and statistics, morphological analysis, resources
allocation, project management as well as many others.

The management scientist's task is to use rational, systematic, science-
based techniques to inform and improve decisions of all kinds. Of course,
the techniques of management science are not restricted to business
applications but may be applied to military, medical, public administration,
political groups, etc.

MS is also concerned with so-called ”soft-operational analysis”, which
concerns methods for strategic planning, strategic decision support, and
problem structuring methods. At this level of abstraction, mathematical
modeling and simulation will not suffice. Therefore, during the last
decades, a number of non-quantified modeling methods have been
developed. This topic is discussed in the Research I.2, Behavioral
Economics/Finance.

2. Management Science Topics
A few examples of applications in which management science/operations
research is currently used include:

- designing the layout of a factory for efficient flow of materials

- make or buy analysis

- M&A decisions

- Private Equity decisions

- investing in new plants or reinvesting in current plants

- introduction/development of new products

- making decisions regarding Oligopoly and Monopoly markets

- constructing a telecommunications network at low cost while still
guaranteeing QoS (quality of service) or QoE (Quality of Experience) if
particular connections become very busy or get damaged

- road traffic management and 'one way' street allocations i.e. allocation
problems.

- determining the routes of school buses (or city buses) so that as few
buses are needed as possible

- designing the layout of a computer chip to reduce manufacturing time
(therefore reducing cost)

- managing the flow of raw materials and products in a supply chain based
on uncertain demand for the finished products

- efficient messaging and customer response tactics

- roboticizing or automating human-driven operations processes

- globalizing operations processes in order to take advantage of cheaper
materials, labor, land or other productivity inputs
- managing freight transportation and delivery systems (Examples: LTL
Shipping, intermodal freight transport)

- scheduling:

- personnel staffing

- manufacturing steps

- project tasks

- network data traffic: these are known as queuing models or queuing
systems.

- sports events and their television coverage

- blending of raw materials in oil refineries

Management Science/Operations research is also used extensively in
government where evidence-based policy is used.

3. Critical Conclusions on Management Science (The
Bounded Rational Decision Making Model)

The Rational Decision Making Model, amongst its many assumptions assumes
that there is a single, best solution that will maximize the desired
outcomes.

The bounded rationality model says that the problems and the decisions are
to be reduced to such a level that they will be understood. In other words,
the model suggests that we should interpret information and extract
essential features and then within these boundaries we take a rational
decision.

The model turns towards compromising on the decision making process
though it is a structured decision making model. The decision maker takes
the decision or is assumed to choose a solution though not a perfect
solution but “good enough” solution based on the limited capacity of the
group leader to handle the complexity of the situation, ambiguity and
information. The steps involved in such decision making are alike to the
rational decision making process. The model assumes that the perfect
knowledge about all the alternatives is not possible for a human being to
know. Hence, based on the limited knowledge he takes a good enough
knowledge though not a perfect decision.

In short, we can say that the decision that is taken is rational but is taken
in a bounded area and the choice of alternatives is though not perfect is
nearer to the perfect decision. In rational process the assumption is that
the exact problem, all the alternatives, should be thoroughly known to the
decision maker. However, the realistic approach of human limitation is
overlooked in rational decision making, but the same approach is considered
mainly in the bounded rational decision making process.

Hence, it is also called as a Realistic Approach for Rational Decision Making
Process.

4 My Comments
There are a lot of assumptions, requirements without which the rational
decision model is a failure. Therefore, they all have to be considered. The
model assumes that we have or should or can obtain adequate information,
both in terms of quality, quantity and accuracy. This applies to the situation
as well as the alternative technical situations. It further assumes that you
have or should or can obtain substantive knowledge of the cause and effect
relationships relevant to the evaluation of the alternatives. In other words,
it assumes that you have a thorough knowledge of all the alternatives and
the consequences of the alternatives chosen. It further assumes that you
can rank the alternatives and choose the best of it. The following are the
limitations for the Rational Decision Making Model:

It requires a great deal of time.

It requires great deal of information

It assumes rational, measurable criteria are available and agreed upon.

It assumes accurate, stable and complete knowledge of all the alternatives,
preferences, goals and consequences.

It assumes a rational, reasonable, non – political world.

Several rational theories and methods are limited, but very much useful
when making business decisions. What one can say is that in other to
improve the outcome, we must combine the rational and irrational methods.
That means, we must implement the prescriptive/rational and
descriptive/irrational/behavioral methods and theories.

5 References
Bernoulli, D (1954) "Exposition of a New Theory on the Measurement of
Risk" (original: 1738), "Econometrica" 22:23-36.

Schoemaker PJH (1982) "The Expected Utility Model: Its Variants,
Purposes, Evidence and Limitations", "Journal of Economic Literature",
20:529-563.

Scott Plous (1993) "The psychology of judgment and decision making",
Chapter 7 (specifically) and 8,9,10, (to show paradoxes to the theory).

Paul Anand, "Foundations of Rational Choice Under Risk", Oxford, Oxford
University Press (an overview of the philosophical foundations of key
mathematical axioms in subjective expected utility theory - mainly
normative) 1993 repr 1995 2002

Sven Ove Hansson, "Decision Theory: A Brief Introduction",
http://www.infra.kth.se/~soh/decisiontheory.pdf (an excellent non-
technical and fairly comprehensive primer)

Paul Goodwin and George Wright, Decision Analysis for Management
Judgment, 3rd edition. Chichester: Wiley, 2004 ISBN 0-470-86108-8
(covers both normative and descriptive theory)

Robert Clemen. Making Hard Decisions: An Introduction to Decision
Analysis, 2nd edition. Belmont CA: Duxbury Press, 1996. (covers normative
decision theory)

D.W. North. "A tutorial introduction to decision theory". IEEE Trans.
Systems Science and Cybernetics, 4(3), 1968. Reprinted in Shafer & Pearl.
(also about normative decision theory)

Glenn Shafer and Judea Pearl, editors. Readings in uncertain reasoning.
Morgan Kaufmann, San Mateo, CA, 1990.

Howard Raiffa Decision Analysis: Introductory Readings on Choices Under
Uncertainty. McGraw Hill. 1997. ISBN 0-07-052579-X
Lev Virine and Michael Trumper. Project Decisions: The Art and Science,
Vienna, VA: Management Concepts, 2008. ISBN 978-1567262179

Morris De Groot Optimal Statistical Decisions. Wiley Classics Library.
2004. (Originally published 1970.) ISBN 0-471-68029-X.

Khemani , Karan, Ignorance is Bliss: A study on how and why humans depend
on recognition heuristics in social relationships, the equity markets and the
brand market-place, thereby making successful decisions, 2005.

J.Q. Smith Decision Analysis: A Bayesian Approach. Chapman and Hall.
1988. ISBN 0-412-27520-1

Akerlof, George A. and Janet L. YELLEN, Rational Models of Irrational
Behavior

Arthur, W. Brian, Designing Economic Agents that Act like Human Agents:
A Behavioral Approach to Bounded Rationality

James O. Berger Statistical Decision Theory and Bayesian Analysis. Second
Edition. 1980. Springer Series in Statistics. ISBN 0-387-96098-8.
RESEARCH PART I.2: Descriptive Theory
– Behavioral Economics/Finance (MBA at
Ohio University)

Expected Utility Theory
The center of prescriptive knowledge (for some wrongly descriptive) about
decision making has been the theory of expected utility (EU). EU theory
defines the conditions of perfect utility-maximizing rationality in a world
of certainty or in a world in which the probability distributions of all
relevant variables can be provided by the decision makers. (As mentioned
earlier, it might be compared with a theory of ideal gases or of frictionless
bodies sliding down inclined planes in a vacuum – ideal state – by Herbert
Simon).

Prescriptive/rational theories of choice such as EU are complemented by
empirical research that shows how people actually make decisions
(purchasing a pension plan, voting for political candidates, buying an
insurance package, or investing in stocks).This research demonstrates that
people make decisions by selective, heuristic search through large problem
spaces and large data bases, using means-ends analysis as a principal
technique for guiding the search.

What distinguishes the descriptive/irrational research on decision making
from the prescriptive/rational approaches derived from EU theory is the
attention that the former gives to the limits on human rationality. These
limits are imposed by the complexity of the world in which we live, the
incompleteness and inadequacy of human knowledge, the inconsistencies of
individual preference and belief, the conflicts of value among people and
groups of people, and the inadequacy of the computations we can carry out,
even with the aid of the most powerful computers. The real world of human
decisions is not a world of an ideal state as mentioned earlier.

The descriptive/irrational theory of decision making is centrally concerned
with all those point mentioned above and also how people cut problems down
to size: how they apply approximate heuristic techniques to handle
complexity that can not be handled exactly. Prospect Theory, after
reviewed as Cumulative Prospect Theory, emerges to take account of the
gaps and elements of unrealism in EU theory.

Cumulative Prospect Theory
Shefrin (2000), p 108

"A theory that incorporates such framing effects has been proposed by Kahneman and
Tversky (1979). Termed prospect theory, it has been extraordinarily influential. It is
based on the idea that people evaluate gains or losses in prospect theory from some
neutral or status quo point, an assumption consistent with the adaptation-level findings
that occur not just in perception but in virtually all experience. That is, we adapt to a
constant level of virtually any psychological dimension and find it to be neutral. In a similar
way, we adapt to the reduced light in a movie theater when we enter it—finding it not
particularly dark after a few seconds—and then readapt to the much brighter light
outside when we leave the theater—finding it not to be unusually bright after a few
seconds.

Thaler (1980)

"First, individuals do not assess risky gambles following the precepts of von Neumann-
Morgenstern rationality. Rather, in assessing such gambles, people look not at the levels of
final wealth they can attain but at gains and losses relative to some reference point, which
may vary from situation to situation, and display loss aversion—a loss function that is
steeper than a gain function. Such preferences—first described and modeled by Kahneman
and Tversky (1979) in their ‘Prospect Theory’—are helpful for thinking about a number of
problems in finance. One of them is the notorious reluctance of investors to sell stocks
that lose value, which comes out of loss aversion (Odean 1998). Another is investors'
aversion to holding stocks more generally, known as the equity premium puzzle (Mehra and
Prescott 1985, Benartzi and Thaler 1995)."

Plous (1993) p 95-96

"Unlike expected utility theory, prospect theory predicts that preferences will depend on
how a problem is framed. If the reference point is defined such that an outcome is viewed
as a gain, then the resulting value function will be concave and decision makers will tend to
be risk averse. On the other hand, if the reference point is defined such that an outcome
is viewed as a loss, then the value function will be convex and decision makers will be risk
seeking."

Cumulative Prospect Theory is a model for descriptive/irrational decisions
under risk which has been introduced by Amos Tversky and Daniel
Kahneman in 1992 (Tversky, Kahneman, 1992). It is a further development
and variant of prospect theory. The difference from the original version of
prospect theory is that weighting is applied to the cumulative probability
distribution function, as in rank-dependent expected utility theory, rather
than to the probabilities of individual outcomes. In 2002, Daniel Kahneman
received the Bank of Sweden Prize in Economic Sciences in Memory of
Alfred Nobel for his contributions to behavioral economics, in particular to
the development of Cumulative Prospect Theory (CPT).

Outline of the model

FIGURE 1

Figure 1 is a typical value function in Prospect Theory and Cumulative
Prospect Theory. It assigns values to possible outcomes of a lottery.

FIGURE 2

Figure 2 is a typical weighting function in Cumulative Prospect Theory. It
transforms objective cumulative probabilities into subjective cumulative
probabilities.

The main observation of CPT (and its predecessor Prospect Theory) is that
people tend to think of possible outcomes usually relative to a certain
reference point (often the status quo) rather than to the final status, a
phenomenon which is called framing effect. Moreover, they have different
risk attitudes towards gains (i.e. outcomes above the reference point) and
losses (i.e. outcomes below the reference point) and care generally more
about potential losses than potential gains (loss aversion). Finally, people
tend to overweight extreme, but unlikely events, but underweight "average“
events. The last point is a difference to Prospect Theory which assumes
that people overweight unlikely events, independently of their relative
outcomes.
CPT incorporates these observations in a modification of Expected Utility
Theory by replacing final wealth with payoffs relative to the reference
point, by replacing the utility function with a value function, depending on
this relative payoff, and by replacing cumulative probabilities with
weighted cumulative probabilities. In the general case, this leads to the
following formula for the subjective utility of a risky outcome described by
the probability measure p:

where v is the value function (typical form shown in Figure 1), w is the

weighting function (as sketched in Figure 2) and , i.e.
the integral of the probability measure over all values up to x, is the
cumulative probability.

This formula is a generalization of the original formulation by Tversky and
Kahneman which allows for arbitrary (continuous) outcomes, and not only
for finitely many distinct outcomes.
The Research – Behavioral Decision Making (MBA-
Master’s Degree at Ohio University- USA)
Behavioral finance and behavioral economics are very close related fields
which apply scientific research on human and social cognitive and emotional
biases, so we can understand economic decisions and how they affect, for
example: stock market prices; the allocation of resources in new and/or
current businesses, as buying/selling out companies; buying/selling stocks,
etc. These two areas are mainly concerned with the economic agents’
rationality and/or the lack of it. Behavioral models typically integrate
insights from psychology with neo-classical economic theory. Behavioral
analyses are mostly concerned with the effects of market decisions, but
also those of public choice, another source of economic decisions with some
similar biases.

Contents:

1 Introduction

2 Key observations

3 Behavioral finance topics

3.1 Behavioral finance models

3.2 Criticisms of behavioral finance

4 Behavioral economics

4.1 Behavioral economics topics

4.2 Critical conclusions of behavioral economics

5 My Comments
6 References
1. Introduction
Economics and psychology had a very close link during the classical period.
The economist Adam Smith wrote The Theory of Moral Sentiments,
describing psychological principles of individual behavior; and Jeremy
Bentham wrote heavily on the psychological foundation of utility.
Economists began to distance themselves from psychology during the
development of neo-classical economics as they sought to reshape the
discipline as a natural science, with explanations of economic behavior
deduced from assumptions about the nature of economic agents. The
concept of homo economicus was developed, and the psychology of this
entity was fundamentally rational. Nevertheless, psychological explanations
continued to inform the analysis of many important figures in the
development of neo-classical economics such as Francis Edgeworth,
Vilfredo Pareto, Irving Fisher and John Maynard Keynes.

A number of factors contributed to the resurgence of usage of psychology
in the economy studies and the development of behavioral economics.
Expected utility and discounted utility models began to gain wide
acceptance, generating testable hypotheses about decision making under
uncertainty and intertemporal consumption respectively. Soon a number of
observed and repeatable anomalies challenged those hypotheses.
Furthermore, during the 1960s cognitive psychology began to describe the
brain as an information processing device (in contrast to behaviorist
models). Psychologists in this field such as Ward Edwards, Amos Tversky
and Daniel Kahneman began to compare their cognitive models of decision
making under risk and uncertainty to economic models of rational behavior.

Perhaps the most important paper in the development of the behavioral
finance and economics fields was written by Kahneman and Tversky in 1979.
This paper, 'Prospect theory: Decision Making Under Risk', used
cognitive psychological techniques to explain a number of documented
anomalies in economic decision making. Further milestones in the
development of the field include a well attended and diverse conference at
the University of Chicago (see Hogarth & Reder, 1987), a special 1997
edition of the Quarterly Journal of Economics ('In Memory of Amos
Tversky') devoted to the topic of behavioral economics and the award of
the Nobel prize to Daniel Kahneman in 2002 "for having integrated insights
from psychological research into economic science, especially concerning
human judgment and decision-making under uncertainty."
Prospect theory is an example of generalized expected utility theory.
Although not commonly included in discussions of the field of behavioral
economics, generalized expected utility theory is similarly motivated by
concerns about the descriptive inaccuracy of expected utility theory.

Richard H. Thaler (b. September 12, 1945, in East Orange, NJ) is an
economist perhaps best known as a theorist in behavioral finance and for
his collaboration with Daniel Kahneman and others in further defining that
field. Thaler has also organized a series of behavioral finance seminars
along with Robert Shiller, another behavioral finance expert at the Yale
School of Management. Thaler gained some attention in the field of
economics for publishing a regular column in the Journal of Economic
Perspectives from 1987 to 1990 titled "Anomalies", in which he documented
individual instances of economic behavior that seemed to violate traditional
microeconomic theory.

Kahneman later cited his joint work with Thaler as a "major factor" in his
receiving the Nobel Prize in Economics, saying "The committee cited me
'for having integrated insights from psychological research into economic
science ….'. Although I do not wish to renounce any credit for my
contribution, I should say that in my view the work of integration was
actually done mostly by Thaler and the group of young economists that
quickly began to form around him."

Thaler also is the founder of an asset management firm that enables a
select group of investors to capitalize on cognitive biases such as the
endowment effect, loss aversion and status quo bias.

Thaler has also written a number of books on the subject of behavioral
finance, including Quasi-rational Economics and The Winner's Curse, the
latter of which contains many of his "Anomalies".

Behavioral economics has also been applied to problems of intertemporal
choice. The most prominent idea is that of hyperbolic discounting, in which
a high rate of discount is used between the present and the near future,
and a lower rate between the near future and the far future. This pattern
of discounting is dynamically inconsistent (or time-inconsistent), and
therefore inconsistent with some models of rational choice, since the rate
of discount between time t and t+1 will be low at time t-1, when t is the
near future, but high at time t when t is the present and time t+1 the near
future.

2. Key observations
There are three main themes in behavioral finance and economics (Shefrin,
2002) (three major points for research !!!!!):

Heuristics: People often make decisions based on approximate rules of
thumb, not strictly rational analyses (see also cognitive biases and bounded
rationality).

Framing (formulating): The way a problem or decision is presented to the
decision maker will affect his action.

Market inefficiencies: There are explanations for observed market
outcomes that are contrary to rational expectations and market efficiency.
These include mispricings, non-rational decision making, and return
anomalies. Richard Thaler, in particular, has written a long series of papers
describing specific market anomalies from a behavioral perspective.

This chart shows word
counts using Lexis Nexis
of the terms "behavioral
finance" and "efficient
markets", by year, in
General News, Major
Papers, Full Text, scaled
by an estimate of the
number of words of text on
Lexis-Nexis for the year.
The chart shows that
"behavioral finance" has
been growing
exponentially starting from
several years after we
began our workshop
series, while "efficient
markets" has been
declining. The chart is
dramatic evidence that
behavioral finance has
been gaining in the
marketplace for ideas.

FIGURE 3 – Behavioral Finance x Efficient Markets

Recently, Barberis, Shleifer, and Vishny (1998), as well as Daniel,
Hirshleifer, and Subrahmanyam (1998) have built models based on
extrapolation (seeing patterns in random sequences) and overconfidence to
explain security market over - and underreactions, though such models have
not been used in the money management industry. These models assume
that errors or biases are correlated across agents so that they do not
cancel out in aggregate (aggregation is the sum of). This would be the case
if a large fraction of agents look at the same signal (such as the advice of
an analyst) or have a common bias.

More generally, cognitive biases may also have strong anomalous effects in
aggregate if there is a social contamination with a strong emotional content
(collective greed or fear), leading to more widespread phenomena such as
herding and groupthink. Behavioral finance and economics rests as much
on social psychology within large groups as on individual psychology
(here we see how important is to understand the aggregation effect).
However, some behavioral models explicitly demonstrate that a small but
significant anomalous group can also have market-wide effects (eg. Fehr
and Schmidt, 1999).

3. Behavioral finance topics
Key observations made in behavioral finance literature include the lack of
symmetry between decisions to acquire or keep resources, called
colloquially the "bird in the bush" paradox, and the strong loss aversion or
regret attached to any decision where some emotionally valued resources
(e.g. a home) might be totally lost. Loss aversion appears to manifest itself
in investor behavior as an unwillingness to sell shares or other equity, if
doing so would force the trader to realize a nominal loss (Genesove &
Mayer, 2001). It may also help explain why housing market prices do not
adjust downwards to market clearing levels during periods of low demand.

Presently, some researchers in Experimental finance use experimental
method, e.g. creating an artificial market by some kind of simulation
software to study people's decision-making process and behavior in
financial markets.

3.1 Behavioral finance models

Some financial models used in money management and asset valuation use
behavioral finance parameters. For example:

-Thaler's model of price reactions to information, with three phases,
underreaction-adjustment-overreaction, creating a price trend. One
characteristic of overreaction is that the average return of asset prices
following a series of announcements of good news is lower than the average
return following a series of bad announcements. In other words,
overreaction occurs if the market reacts too strongly or for too long
(persistent trend) to news that it subsequently needs to be compensated in
the opposite direction. As a result, assets that were winners in the past
should not be seen as an indication to invest in as their risk adjusted
returns in the future are relatively low compared to stocks that were
defined as losers in the past.

3.2 Criticisms of behavioral finance

Critics of behavioral finance, such as Eugene Fama, typically support the
efficient market theory (though Fama may have reversed his position in
recent years). They contend that behavioral finance is more a collection of
anomalies than a true branch of finance and that these anomalies will
eventually be priced out of the market or explained by appealing to market
microstructure arguments. However, a distinction should be noted between
individual biases and social biases; the former can be averaged out by the
market, while the other can create feedback loops that drive the market
further and further from the equilibrium of the "fair price".

A specific example of this criticism is found in some attempted
explanations of the equity premium puzzle. It is argued that the puzzle
simply arises due to entry barriers (both practical and psychological) which
have traditionally impeded entry by individuals into the stock market, and
that returns between stocks and bonds should stabilize as electronic
resources open up the stock market to a greater number of traders (See
Freeman, 2004 for a review). In reply, others contend that most personal
investment funds are managed through superannuation funds, so the effect
of these putative barriers to entry would be minimal. In addition,
professional investors and fund managers seem to hold more bonds than
one would expect given return differentials.

4. Behavioral economics
Models in behavioral economics are typically addressed to a particular
observed market anomaly and modify standard neo-classical models by
describing decision makers as using heuristics and being affected by
framing effects. In general, behavioral economics sits within the
neoclassical framework, though the standard assumption of rational
behavior is often challenged.
4.1 Behavioral Economics topics

Heuristics - Prospect theory - Loss aversion - Status quo bias -
Gambler's fallacy - Self-serving bias - money illusion

Framing - Cognitive framing - Mental accounting - Anchoring

Anomalies (economic behavior) - Disposition effect - endowment
effect - inequity aversion - reciprocity - intertemporal consumption -
present-biased preferences - momentum investing - Greed and fear - Herd
instinct

Anomalies (market prices and returns)- Equity premium puzzle -
Efficiency wage hypothesis - price stickiness - limits to arbitrage -
dividend puzzle - fat tails - calendar effect

4.2 Critical conclusions of behavioral economics

Critics of behavioral economics typically stress the rationality of economic
agents (see Myagkov and Plott (1997) amongst others). They contend that
experimentally observed behavior is inapplicable to market situations, as
learning opportunities and competition will ensure at least a close
approximation of rational behavior.

Others note that cognitive theories, such as prospect theory, are models
of decision making, not generalized economic behavior, and are only
applicable to the sort of once-off decision problems presented to
experiment participants or survey respondents.

Traditional economists are also skeptical of the experimental and survey
based techniques which are used extensively in behavioral economics.
Economists typically stress revealed preferences, over stated preferences
(from surveys) in the determination of economic value. Experiments and
surveys must be designed carefully to avoid systemic biases, strategic
behavior and lack of incentive compatibility, and many economists are
distrustful of results obtained in this manner due to the difficulty of
eliminating these problems.

Rabin (1998) dismisses these criticisms, claiming that results are typically
reproduced in various situations and countries and can lead to good
theoretical insight. Behavioral economists have also incorporated these
criticisms by focusing on field studies rather than lab experiments. Some
economists look at this split as a fundamental schism between experimental
economics and behavioral economics, but prominent behavioral and
experimental economists tend to overlap techniques and approaches in
answering common questions. For example, many prominent behavioral
economists are actively investigating neuroeconomics, which is entirely
experimental and cannot be verified in the field.

Other proponents of behavioral economics note that neoclassical models
often fail to predict outcomes in real world contexts. Behavioral insights
can be used to update neoclassical equations, and behavioral economists
note that these revised models not only reach the same correct predictions
as the traditional models, but also correctly predict some outcomes where
the traditional models failed.

Behavioral analyses are mostly concerned with the effects of market
decisions, but also those of public choice, another source of economic
decisions with some similar biases.

5. My Comments
Empirical studies of choice under uncertainty

For the last decades, researchers have worked hard on empirical studies of
human choices in which uncertainty, risk, inconsistency, and incomplete
information are present.

On the basis of these studies, some of the general heuristics, or rules of
thumb, that people use in making judgments have been compiled – heuristics
that produce biases toward classifying situations according to their
representativeness, or toward judging frequencies according to the
availability of examples in memory, or toward interpretations biased by the
way in which a problem has been framed. Cognitive bias is distortion in the
way humans perceive reality. Some of these have been verified empirically
in the field of psychology, others are considered general categories of bias.

A bias is a prejudice in a general or specific sense, usually in the sense for
having a preference to one particular point of view or ideological
perspective. However, one is generally only said to be biased if one's
powers of judgment are influenced by the biases one holds, to the extent
that one's views could not be taken as being neutral or objective, but
instead as subjective. A bias could, for example, lead one to accept or deny
the truth of a claim, not on the basis of the strength of the arguments in
support of the claim themselves, but because of the extent of the claim's
correspondence with one's own preconceived ideas. This is called
confirmation bias.

A systematic bias is a bias resulting from a flaw integral to the system
within which the bias arises (for example, an incorrectly calibrated
thermostat may consistently read — that is 'be biased' — several degrees
hotter or colder than actual temperature). As a consequence, systematic
bias commonly leads to systematic errors, as opposed to random errors,
which tend to cancel one another out.

In practice, accusations of bias often result from a perception of
unacknowledged favoritism on the part of a critic or judge, or indeed any
person in a position requiring the careful and disinterested exercise of
arbitration or assessment. Any tendency to favor a certain set of values
naturally leads to an uneven dispensation of judgment. It may also be noted
that, if a person were to take their own preexisting view as a priori
balanced without acknowledging their own personal inclinations, any person
or organization that disagrees with their views is likely to be viewed as
biased regardless of that person or organization's actual efforts at
balance. It may be observed that bias is, in a sense, reflexive,
unacknowledged or unrecognized bias potentially leading to its apprehension
(with or without good reason) in others.

Methods of empirical research

Finding the underlying bases of human choice behavior is difficult. People
cannot always, or perhaps even usually, provide veridical accounts of how
they make up their minds, especially when there is uncertainty. In many
cases, they can predict how they will behave (pre-election polls of voting
intentions have been reasonably accurate when carefully taken), but the
reasons people give for their choices can often be shown to be
rationalizations and not closely related to their real motives.

Students of choice behavior have steadily improved their research
methods. They question respondents about specific situations, rather than
asking for generalizations. They are sensitive to the dependence of
answers on the exact forms of the questions. They are aware that behavior
in an experimental situation may be different from behavior in real life, and
they attempt to provide experimental settings and motivations that are as
realistic as possible. Using thinking-aloud protocols and other approaches,
they try to track the choice behavior step by step, instead of relying just
on information about outcomes or querying respondents retrospectively
about their choice processes.

Perhaps the most common method of empirical research in this field is still
to ask people to respond to a series of questions. But data obtained by this
method are being supplemented by data obtained from carefully designed
laboratory experiments and from observations of actual choice behavior
(for example, the behavior of customers in supermarkets). In an
experimental study of choice, subjects may trade in an actual market with
real (if modest) monetary rewards and penalties. Research experience has
also demonstrated the feasibility of making direct observations, over
substantial periods of time, of the decision-making processes in business
and governmental organizations--for example, observations of the
procedures that corporations use in making new investments in plant and
equipment. Confidence in the empirical findings that have been
accumulating over the past several decades is enhanced by the general
consistency that is observed among the data obtained from quite different
settings using different research methods.

There still remains the enormous and challenging task of putting together
these findings into an empirically founded theory of decision making. With
the growing availability of data, the theory-building enterprise is receiving
much better guidance from the facts than it did in the past. As a result, we
can expect it to become correspondingly more effective in arriving at
realistic models of behavior.

Decision making over time (point for research….)

The time dimension is some how a difficult variable to deal with in decision
making. Economics has always used the notion of time discounting and
interest rates to compare present with future consequences of decisions,
but as noted above, research on actual decision making shows that people
frequently are inconsistent in their choices between present and future.
Although time discounting is a powerful idea, it requires fixing appropriate
discount rates for individual, and especially social, decisions. Additional
problems arise because human tastes and priorities change over time.
Classical SEU theory assumes a fixed, consistent utility function, which
does not easily accommodate changes in taste.
Aggregation (point for research….)

Overview

When applying our knowledge of decision making to society-wide, or even
organization-wide (agency theory), the problem of aggregation must be
solved; that is, ways must be found to extrapolate from theories of
individual decision processes to the net effects on the whole economy,
policy, and society. Because of the wide variety of ways in which any given
decision task can be approached, it is unrealistic to postulate a
"representative firm" or a "standard economic man," and to simply lump
together the behaviors of large numbers of supposedly identical individuals.
Solving the aggregation problem becomes more important as more of the
empirical research effort is directed toward studying behavior at a
detailed, microscopic level.

Organizations

Organizations sometimes display sophisticated capabilities far beyond the
understanding of single individuals. They sometimes make enormous
blunders or find themselves incapable of acting. Organizational
performance is highly sensitive to the quality of the routines or
"performance programs" that govern behavior and to the adaptability of
these routines in the face of a changing environment. In particular, the
"peripheral vision" of a complex organization is limited, so that responses to
novelty in the environment may be made in inappropriate and quasi-
automatic ways that cause major failure.

Theory development, formal modeling, laboratory experiments, and analysis
of historical cases are all going forward in this important area of inquiry.
Although the decision-making processes of organizations have been studied
in the field on a limited scale, a great many more such intensive studies will
be needed before the full range of techniques used by organizations to
make their decisions is understood, and before the strengths and
weaknesses of these techniques are grasped.

Learning (Market efficiency improves with time ? Internet
influence? ……….) - (point for research….)

Until quite recently, most research in cognitive science and artificial
intelligence had been aimed at understanding how intelligent systems
perform their work. Only in the last decades has attention begun to turn to
the question of how systems become intelligent--how they learn. A number
of promising hypotheses about learning mechanisms are currently being
explored. One is the so-called connexionist hypothesis, which postulates
networks that learn by changing the strengths of their interconnections in
response to feedback. Another learning mechanism that is being
investigated is the adaptive production system, a computer program that
learns by generating new instructions that are simply annexed to the
existing program. Some success has been achieved in constructing adaptive
production systems that can learn to solve equations in algebra and to do
other tasks at comparable levels of difficulty.

The Limits of Rationality (point for research….)

Computational complexity is not the only factor that limits the literal
application of EU theory. The theory also makes enormous demands on
information. For the utility function, the range of available alternatives and
the consequences following from each alternative must all be known.
Increasingly, research is being directed at decision making that takes
realistic account of the compromises and approximations that must be
made in order to fit real-world problems to the informational and
computational limits of people and computers, as well as to the
inconsistencies in their values and perceptions. The study of actual decision
processes (for example, the strategies used by corporations to make their
investments) reveals massive and unavoidable departures from the
framework of SEU theory. The sections that follow describe some of the
things that have been learned about choice under various conditions of
incomplete information, limited computing power, inconsistency, and
institutional constraints on alternatives. Game theory, agency theory,
choice under uncertainty, and the theory of markets are a few of the
directions of this research, with the aims both of constructing prescriptive
theories of broader application and of providing more realistic descriptions
and explanations of actual decision making within U.S. economic and political
institutions.

Limited Rationality in Economic theory

Although the limits of human rationality were stressed by some
researchers in the 1950s, only recently has there been extensive activity in
the field of economics aimed at developing theories that assume less than
fully rational choice on the part of business firm managers and other
economic agents. The newer theoretical research undertakes to answer
such questions as the following:
• Are market equilibria altered by the departures of actual choice
behavior from the behavior of fully rational agents predicted by Expected
Utility Theory?

• Under what circumstances do the processes of competition "police"
markets in such a way as to cancel out the effects of the departures from
full rationality?

• In what ways are the choices made by bounded rational agents
different from those made by fully rational agents?

Theories of the firm that assume managers are aiming at "satisfactory"
profits or that their concern is to maintain the firm's share of market in
the industry make quite different predictions about economic equilibrium
than those derived from the assumption of profit maximization. Moreover,
the classical theory of the firm cannot explain why economic activity is
sometimes organized around large business firms and sometimes around
contractual networks of individuals or smaller organizations. New theories
that take account of differential access of economic agents to information,
combined with differences in self-interest, are able to account for these
important phenomena, as well as provide explanations for the many forms
of contracts that are used in business. Incompleteness and asymmetry of
information have been shown to be essential for explaining how individuals
and business firms decide when to face uncertainty by insuring, when by
hedging, and when by assuming the risk.

Most current work in this domain still assumes that economic agents seek
to maximize utility, but within limits posed by the incompleteness and
uncertainty of the information available to them. An important potential
area of research is to discover how choices will be changed if there are
other departures from the axioms of rational choice--for example,
substituting goals of reaching specified aspiration levels (satisficing) for
goals of maximizing.

Applying the new assumptions about choice to economics leads to new
empirically supported theories about decision making over time. The
classical theory of perfect rationality leaves no room for regrets, second
thoughts, or “weakness of will

Some researchers state that there are no evidences confirming that
markets like the New York Stock Exchange work efficiently--that prices
reflect all available information at any given moment in time, so that stock
price movements resemble a random walk and contain no systematic
information that could be exploited for profit. Recently, however,
substantial departures from the behavior predicted by the efficient-
market hypothesis have been detected. All of these results are consistent
with the empirical finding that decision makers often overreact to new
information. In the same way, it has been found that stock prices are
excessively volatile--that they fluctuate up and down more rapidly and
violently than they would if the market were efficient.

6. References
Camerer, C. F.; Loewenstein, G. & Rabin, R. (eds.) (2003) Advances in
Behavioral Economics

Barberis, N.; A. Shleifer; R. Vishny (1998) ``A Model of Investor
Sentiment Journal of Financial Economics 49, 307-343.

Daniel, K.; D. Hirshleifer; A. Subrahmanyam, (1998) ``Investor Psychology
and Security Market Over- and Underreactions Journal of Finance 53,
1839-1885.

Lawrence A. Cunningham, Behavioral Finance and Investor Governance, 59
Washington & Lee Law Review (2002)

Kahneman, D. & Tversky, A. 'Prospect Theory: An Analysis of Decision
under Risk,' Econometrica, XVLII (1979), 263–291

Matthew Rabin 'Psychology and Economics,' Journal of Economic
Literature, American Economic Association, vol. 36(1), pages 11-46, March
1998.

Shefrin, Hersh (2002) Beyond Greed and Fear: Understanding behavioral
finance and the psychology of investing. Oxford Universtity Press

Shleifer, Andrei (1999) Inefficient Markets: An Introduction to Behavioral
Finance, Oxford University Press

Shlomo Benartzi; Richard H. Thaler 'Myopic Loss Aversion and the Equity
Premium Puzzle' (1995) The Quarterly Journal of Economics, Vol. 110, No. 1.
RESEARCH PART I.3: Strategic Management

Strategic management
Strategic management is the art and science of formulating, implementing
and evaluating cross-functional decisions that will enable an organization to
achieve its objectives[1]. It is the process of specifying the organization's
objectives, developing policies and plans to achieve these objectives, and
allocating resources to implement the policies and plans to achieve the
organization's objectives. Strategic management, therefore, combines the
activities of the various functional areas of a business to achieve
organizational objectives. Strategic management provides overall direction
to the enterprise and is closely related to the field of Organization
Studies.

“Strategic management is an ongoing process that assesses the business
and the industries in which the company is involved; assesses its
competitors and sets goals and strategies to meet all existing and potential
competitors; and then reassesses each strategy annually or quarterly (i.e.
regularly) to determine how it has been implemented and whether it has
succeeded or needs replacement by a new strategy to meet changed
circumstances, new technology, new competitors, a new economic
environment., or a new social, financial, or political environment.” (Lamb,
1984:ix)[2]

Contents

1 Processes

1.1 Strategy formulation

1.2 Strategy implementation

1.3 Strategy evaluation

2 General approaches

3 The strategy hierarchy

4 Reasons why strategic plans fail

5 Criticisms of strategic management
6 My Comments
7 References

1 Processes

Strategic management is a combination of three main processes which are
as following:

1.1 Strategy formulation

Performing a situation analysis, self-evaluation and competitor analysis:
both internal and external; both micro-environmental and macro-
environmental.

Concurrent with this assessment, objectives are set. This involves crafting
vision statements (long term view of a possible future), mission statements
(the role that the organization gives itself in society), overall corporate
objectives (both financial and strategic), strategic business unit objectives
(both financial and strategic), and tactical objectives.

These objectives should, in the light of the situation analysis, suggest a
strategic plan. The plan provides the details of how to achieve these
objectives.

This three-step strategy formulation process is sometimes referred to as
determining where you are now, determining where you want to go, and then
determining how to get there.

1.2 Strategy implementation

Allocation of sufficient resources (financial, personnel, time, technology
support)

Establishing a chain of command or some alternative structure (such as
cross functional teams)

Assigning responsibility of specific tasks or processes to specific
individuals or groups
It also involves managing the process. This includes monitoring results,
comparing to benchmarks and best practices, evaluating the efficacy and
efficiency of the process, controlling for variances, and making
adjustments to the process as necessary.

When implementing specific programs, this involves acquiring the requisite
resources, developing the process, training, process testing, documentation,
and integration with legacy processes.

1.3 Strategy evaluation

The effectiveness of the organizational strategy must be measured. A good
system/philosophy to support is the Balanced Scorecard (BSC)

2. General approaches

In general terms, there are two main approaches, which are opposite
but complement each other in some ways, to strategic management:

The Industrial Organization Approach: based on economic theory — deals
with issues like competitive rivalry, resource allocation, economies of scale
assumptions — rationality, self discipline behavior, profit maximization.
(Research I.1)

The Behavioral/Sociological Approach: deals primarily with human
interactions assumptions — bounded rationality, cognitive biases, satisfying
behavior, profit sub-optimality. (Research I.2)

Strategic management techniques can be viewed as bottom-up, top-down, or
collaborative processes. In the bottom-up approach, employees submit
proposals to their managers who, in turn, funnel the best ideas further up
the organization. This is often accomplished by a capital budgeting process.
Proposals are assessed using financial criteria such as return on investment
or cost-benefit analysis. The proposals that are approved form the
substance of a new strategy, all of which is done without a grand strategic
design or a strategic architect. The top-down approach is the most common
by far. In it, the CEO possibly with the assistance of a strategic planning
team, decides on the overall direction the company should take. Some
organizations are starting to experiment with collaborative strategic
planning techniques that recognize the emergent nature of strategic
decisions.

3 The strategy hierarchy

In most (large) corporations there are several levels of strategy. Strategic
management is the highest in the sense that it is the broadest, applying to
all parts of the firm. It gives direction to corporate values, corporate
culture, corporate goals, and corporate missions. Under this broad
corporate strategy there are often functional or business unit strategies.

Functional strategies include marketing strategies, new product
development strategies, human resource strategies, financial strategies,
legal strategies, supply-chain strategies, and information technology
management strategies. The emphasis is on short and medium term plans
and is limited to the domain of each department’s functional responsibility.
Each functional department attempts to do its part in meeting overall
corporate objectives, and hence to some extent their strategies are
derived from broader corporate strategies.

Many companies feel that a functional organizational structure is not an
efficient way to organize activities so they have reengineered according to
processes or strategic business units (called SBUs). A strategic business
unit is a semi-autonomous unit within an organization. It is usually
responsible for its own budgeting, new product decisions, hiring decisions,
and price setting. An SBU is treated as an internal profit centre by
corporate headquarters. Each SBU is responsible for developing its
business strategies, strategies that must be in tune with broader
corporate strategies.

The “lowest” level of strategy is operational strategy. It is very narrow in
focus and deals with day-to-day operational activities such as scheduling
criteria. It must operate within a budget but is not at liberty to adjust or
create that budget. Operational level strategy was encouraged by Peter
Drucker in his theory of management by objectives (MBO). Operational
level strategies are informed by business level strategies which, in turn,
are informed by corporate level strategies. Business strategy, which refers
to the aggregated operational strategies of single business firm or that of
an SBU. in a diversified corporation, refers to the way in which a firm
competes in its chosen arenas.
Corporate strategy, then, refers to the overarching strategy of the
diversified firm. Such corporate strategy answers the questions of "in
which businesses should we compete?" and "how does being in one business
add to the competitive advantage of another portfolio firm, as well as the
competitive advantage of the corporation as a whole?"

4. Reasons why strategic plans fail

There are many reasons why strategic plans fail, especially:

- Failure to understand the customer

- Why do they buy

- Is there a real need for the product inadequate or incorrect marketing
research

- Inability to predict environmental reaction

- What will competitors do

- Fighting brands

- Price wars

- Will government intervene

- Over-estimation of resource competence

- Can the staff, equipment, and processes handle the new strategy

- Failure to develop new employee and management skills

- Failure to coordinate

- Reporting and control relationships not adequate

- Organizational structure not flexible enough

- Failure to obtain senior management commitment

- Failure to get management involved right from the start

- Failure to obtain sufficient company resources to accomplish task
- Failure to obtain employee commitment

- New strategy not well explained to employees

- No incentives given to workers to embrace the new strategy

- Under-estimation of time requirements

- No critical path analysis done

- Failure to follow the plan

- No follow through after initial planning

- No tracking of progress against plan

- No consequences for above

- Failure to manage change

- Inadequate understanding of the internal resistance to change

- Lack of vision on the relationships between processes, technology and
organization

- Poor communications

- Insufficient information sharing among stakeholders

- Exclusion of stakeholders and delegates

5. Criticisms of strategic management

Although a sense of direction is important, it can also stifle creativity,
especially if it is rigidly enforced. In an uncertain and ambiguous world,
fluidity can be more important than a finely tuned strategic compass. When
a strategy becomes internalized into a corporate culture, it can lead to
group think. It can also cause an organization to define itself too narrowly.
An example of this is marketing myopia.

Many theories of strategic management tend to undergo only brief periods
of popularity. A summary of these theories thus inevitably exhibits
survivorship bias (itself an area of research in strategic management).
Many theories tend either to be too narrow in focus to build a complete
corporate strategy on, or too general and abstract to be applicable to
specific situations. Populism or faddishness can have an impact on a
particular theory's life cycle and may see application in inappropriate
circumstances. See business philosophies and popular management theories
for a more critical view of management theories.

In 2000, Gary Hamel coined the term strategic convergence to explain the
limited scope of the strategies being used by rivals in greatly differing
circumstances. He lamented that strategies converge more than they
should, because the more successful ones get imitated by firms that do not
understand that the strategic process involves designing a custom strategy
for the specifics of each situation.

Ram Charan, aligning with a popular marketing tagline, believes that
strategic planning must not dominate action. "Just do it!", while not quite
what he meant, is a phrase that nevertheless comes to mind when
combating analysis paralysis.

6. My Comments
Strategic Dynamics research is the next step of my research. Researchers
have confirmed with deep studies that corporate strategy, which is of my
interest, is very dynamic. Globalization brings worldwide effects inside the
company, i.e., actions/events in Asia will affect the operations in North
America, if for example, production cost is lower in Asia. Customers may
ask to ship parts from low cost countries. How to react fast on such issue?
So, one may say that flexibility is strategic right for multinational
companies. For customers react fast is a must, and how to make such
decisions and implement it, is a key point to be investigated, so corporate
can achieve success in this dynamic business world.

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*****************END OF RESEARCH PART I ********************
RESEARCH PART II: Strategy Dynamics
(PhD at ………, 2009 - 2012)
Strategy Dynamics
The dynamic model of strategy is a way of understanding how strategic
actions occur. It recognizes that strategic planning is dynamic, that is,
strategy involves a complex pattern of actions and reactions. It is partially
planned and partially unplanned.

Contents

1 The Dynamic Model of Strategy

2 Criticisms of Dynamic Strategy Models

3 References

1. The Dynamic Model of Strategy

Several theorists have recognized a problem with this static model: it is
not how it is done in real life. Strategy is actually a dynamic and interactive
process. Some of the earliest challenges to the planned strategy approach
came from Linblom in the 1960s and Quinn in the 1980s.

Charles Lindblom (1959) claimed that strategy is a fragmented process of
serial and incremental decisions. He viewed strategy as an informal process
of mutual adjustment with little apparent coordination.

James Brian Quinn (1980) developed an approach that he called "logical
incrementalism". He claimed that strategic management involves guiding
actions and events towards a conscious strategy in a step-by-step process.
Managers nurture and promote strategies that are themselves changing. In
regard to the nature of strategic management he says: "Constantly
integrating the simultaneous incremental process of strategy formulation
and implementation is the central art of effective strategic management."
(?page 145). Whereas Lindblom saw strategy as a disjointed process
without conscious direction, Quinn saw the process as fluid but
controllable.

Joseph Bower (1970) and Robert Burgelman (1980) took this one step
further. Not only are strategic decisions made incrementally rather than as
part of a grand unified vision, but according to them, this multitude of
small decisions are made by numerous people in all sections and levels of
the organization.

Henry Mintzberg (1978) made a distinction between deliberate strategy
and emergent strategy. Emergent strategy originates not in the mind of
the strategist, but in the interaction of the organization with its
environment. He claims that emergent strategies tend to exhibit a type of
convergence in which ideas and actions from multiple sources integrate into
a pattern. This is a form of organizational learning, in fact, on this view,
organizational learning is one of the core functions of any business
enterprise (See Peter Senge's The Fifth Discipline (1990).)

Constantinos Markides (1999) describes strategy formation and
implementation as an on-going, never-ending, integrated process requiring
continuous reassessment and reformation.

A particularly insightful model of strategy dynamics comes from J.
Moncrieff (1999). He recognized that strategy is partially deliberate and
partially unplanned. The unplanned element comes from two sources :
“emergent strategies” result from the emergence of opportunities and
threats in the environment and “Strategies in action” are ad hoc actions by
many people from all parts of the organization. These multitudes of small
actions are typically not intentional, not teleological, not formal, and not
even recognized as strategic. They are emergent from within the
organization, in much the same way as “emergent strategies” are emergent
from the environment.

In this model, strategy is both planned and emergent, dynamic, and
interactive. Five general processes interact. They are strategic intention,
the organization's response to emergent environmental issues, the
dynamics of the actions of individuals within the organization, the alignment
of action with strategic intent, and strategic learning.

2. Criticisms of Dynamic Strategy Models
Some detractors claim that these models are too complex to teach. No one
will understand the model until they see it in action. Accordingly, the two
part linear categorization scheme is probably more valuable in textbooks
and lectures.

Also, there are some implementation decisions that do not fit a dynamic
model. They include specific project implementations. In these cases
implementation is exclusively tactical and often routinized. Strategic intent
and dynamic interactions influence the decision only indirectly. This is
edited part :)

5. References

Bower, J. (1970). Managing the resource allocation process : A study of
planning and investment, Graduate school of business (papers), Harvard
University, Boston, 1970.

Burgelman, R. (1980). Managing Innovating systems: A study in the process
of internal corporate venturing, Graduate school of business (PhD
dissertation), Columbia University, 1980.

Lindblom, C. (1959). The science of muddling through, Public Administration
Review, Vol. 19, No. 2, 1959, pp 79-81.

Markides, C. (1999). A dynamic view of strategy. Sloan Management Review,
vol 40, spring 1999, pp 55-63.

Markides, C. (1997). Strategic innovation. Sloan Management Review, vol 38,
spring 1997, pp 31-42.

Moncrieff, J. (1999). Is strategy making a difference? Long Range Planning
Review, vol 32, no 2, pp 273-276.

Mintzberg, H. (1978). Patterns in Strategy Formation, Management
Science, Vol 24, No 9, 1978, pp 934-948.

Quinn, B. (1980). Strategies for Change: Logical Incrementalism, Irwin,
Homewood Ill, 1980.