FOOL'S EYE VIEW
Make Money By Making Better Decisions

By David Kuo (TMFDragon)
January 17, 2002

Carburton Street, London -- How easy do you find making decisions? Do you find yourself prevaricating on even simple issues like what to have for dinner or what clothes to wear in the morning? If so, you are not alone! Apparently, millions of people have trouble making even the simplest of decisions. These decision-evaders will often abdicate choice making to those who, for some unfathomable reason, seem more able to make the right call time and time again.

There are some who believe that the ability to make intelligent decisions is dependent on a brain structure called the ventromedial prefrontal cortex (VPC). Apparently, those people whose VPCs have been damaged in some way can be less able to make good decisions.

But decision-making and the ability to make better decisions is quite often the result of practice. It is quite astonishing to think that that we are not given any guidance in our schools that might help us to be better decision makers. So we need to learn to accept that we will not be able to make the right decisions every time and we will make mistakes. So the important issue here is to try and minimise the risk of making what could be the wrong decision.

Let us take, for example, an issue that most homeowners are facing. Namely whether to fix their mortgage at current interest rate levels.

You could ask you friends and relatives and find out what they all think, noting down their views as you go along. This process is known as consensus decision-making. Consensus doesn't imply that the decision, which is eventually made, is necessarily the right one. But collective intelligence can often help to produce better solutions than any single individual.   

However, to make an informed choice, we need to clarify the situation that we are confronted with. Clearly, in the case of the interest rate puzzle, there are only two choices: namely to fix or not to fix that interest rate at today's level. Remember, that there are three possible outcomes for each choice that you eventually make -- interest rates might rise, they could remain unchanged or they could fall when the Bank of England has it next get-together.

Next you need to assess each option and this is where things can get a bit more involved. Let's say your current standard variable mortgage rate is 5.95% on a mortgage of £100,000 for 25 years and you have the option of fixing the rate at 6.1% for a period of 2 years. Your current repayment mortgage payments are £641 a year but fixing the rate at 6.1% would push your payments up to £650.

You have also estimated that there is a 50% chance interest rates (and your mortgage rate) will rise by 0.5%, a 40% chance it remains unchanged and a 10% probability that interest rates (and your mortgage rate) might go down by 0.5%. A rate rise of 0.5% would push up your monthly payments up to £671 and a fall of 0.5% would reduce your monthly payments to £611.

So how does all this stack up? If you fix your interest rate at 6.1% you will be £9 a month worse off if rates remain unchanged, £21 better off if rates rose by 0.5% and £39 worse off of rates fell by 0.5%. However, by not opting to fix your mortgage, you would be £30 worse off if rates increased by 0.5% and £30 better off if rates fell by 0.5%.

These numbers are known as the conditional values (CV) and are a measure of the amount of profit or loss that would result from your decision. The expected value (EV), or the expected monetary value of each action, can then be calculated by multiplying the probability of the event occurring by the conditional value.

     Event           Probability                 Actions
                                       Fix  Rate       Don't Fix Rate
                                       CV    EV           CV   EV

    Rate Rise           0.50           £21  £10.50       -£30  -£15 
    Rate Unchanged      0.40           -£9  -£3.60         £0    £0
    Rate Fall           0.10          -£39  -£3.90       +£30    £3

    Totals                                   £3                -£12     

In this example, there is a small advantage to be gained by fixing your mortgage rate but much would depend on the level of confidence you attach to assigning the probability of each event occurring. But whether you are considering fixing your mortgage interest rate, or making other financial or investments decisions, the same procedure can be followed. Just remember you need to clarify the situation, identify the options, assess each option and then make your decision.