The Art of Decision Making using Real Options

February 8, 2014 • Tell FriendsPrinter Friendly

This article is based on the recent published book “commitment” in 2013 that was written by Chris Matts and Olav Maassen.
Based on their study, Real Option concept can be used to guide us when to make decision in our life or business.

Overview

Currently, real options is well known as an advance approach in project valuation. However, real options is not only talking about valuation techniques which is very mathematics, it is also talking about the decision making process for managing uncertainty and risk.

The most important aspect on real options is it can guide us when we should decide rather than how to decide. By understanding and responding to the psychological effects uncertainty has on our behavior, we can make better decisions in our life or business.

As financial options theory, Real Options has:

  • a value.
  • an expiration date or condition.
  • a cost for buying the option as well as exercising the option.

The concept of real options mindset is

  • Don’t try to decide too fast. Only decide when you must or have a good reason
  • Meanwhile, look for more information and options
  • Keep as many options open for as long as possible.
  • Maximize your understanding of each option by implement it quickly until the moment you have to decide.
  • Never commit early unless you know why

Option vs Commitment

The important thing to implement real options, we should understand what is a difference between options and commitment.
Suppose you have an appointment with your friend tomorrow afternoon. It looks like a commitment. But, suddenly, after you deal with your friend, you get an invitation to attend a concert tomorrow afternoon. In fact, this concert is what you dreamed of all this time. Do you still want to meet your friend tomorrow or you want to reschedule it? According to this situation, it seems that the appointment with your friend is not a commitment; it’s an option because you still have a choice to reschedule it.

So, commitment is a condition in the last point at which a decision should be made.

Right or Wrong decision, or No Decision

Given any decision to be made, there are three possible decision categories, namely, a “right decision”, a “wrong decision” and “no decision”. Most people think there are only two; you’re either right or you’re wrong. As we face uncertainty in the future, we do not know which is the right or wrong decision. In this case, the optimal decision is in fact “no decision” as this defers the commitment until we have more information to make a better informed decision.

As illustrated in the scheme above, by deferring our commitment into the last responsible moment, the more information we get, the more confident we decide due to decrease of uncertainty level.

However, most people deferring commitment causes stress to many people. We always decide quickly to avoid uncertainty even though we have limited information.
Real options try to help you manage that stress by creating some options in response on the uncertain condition. This is a new way how you look at the world around you by learning to differentiate between options and commitments, then learning which processes adopt real options and which do not.

The Optimal Decision Process

The optimal decision process is described in the below scheme.

Principles to make decision using Real Options

There are some principles to help us making decision using real Options, i.e.:

1. Timing Principle:  Timing is everything, Wait to make decisions until the conditions are correct. (postpone if still possible)
2. Principle of the right moment: If the decision is easy to change, decide early. However, if the decision is hard to change, make it easier to change or delay the decision date.
3. Minimum Effort Principle: If you get an assignment for tomorrow, don’t do that today.
4. The laziness principle: Don’t do anything today that makes tomorrow’s work more difficult

Simple Case

Supposed you have a plan to attend the overseas conference next months.
There are 3 options of transportation that you can use to go to the conference, i.e.:
1. If you choose ship, you should go 14 days before the date of conference
2. If you choose train, you can go 7 days before the date of conference
3. If you choose plane, you can go 2 days before the date of conference
For each options of transportation, you should implement them by spending some money for booking the ticket.

As describe above, there will be three Decision Gates (DG) for you to decide whether you still want to attend the conference or not.
At DG1, if you think that the conference is still worth for you but you cannot go by ship due to some works, you can switch the transportation mode from ship to train.
At DG2, if you still want to go to the conference but you cannot go due to some other reasons, you can switch the transportation mode from train to airplane.
At DG3, you should decide whether you will go to the conference or not because this is the deadline for you (commitment).
If you think the conference is valuable for you, you can decide to go to the conference. However, If you think value of your works is more valuable than attending the conference (includes the registration fee and tickets forfeited), perhaps you should decide to withdraw. So, first consider the value of option that you select, then the cost.

Conclusion

Based on the above explanation, we know that real options is not talking about probability only, it advise us how to survive in facing uncertainty condition.
If your time it takes to recover the bad condition is greater than the time you can survive, you will die. This means that you need more options and maintain them continuously in small steps.
So, from now, stop guessing to decide something when you have limited information, just create options and try to implement them quickly to mitigate all the condition happened in the future.
The most important thing is do all the process by prayer. May we get the best result.

Do the best and Let God decide the rest

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