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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA


par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010
  

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2.10 The Decision-Making Process

Decisions are not arrived at in a vacuum; they rely on personal resources and some complex models that sometimes do not relate to the situation. This process most of the time encompasses the specific problem faced by the individual as well as extending to their environment. The decision-making process can be defined as the process of choosing a particular alternative from a number of alternatives. According to Mathews, 2005, it is an activity that follows after a proper evaluation of all other alternatives.

However, the Normative Theory of Decision-Making tries to explain the whole idea about the decision-making process and what economists as well as other finance scholars think of it. This theory aims at explaining the actual behaviour of an agent focusing on a rational decision-maker whose aim is that of maximising utility. Applicable to this theory are three economic conditions of risk, certainty (known possible outcomes) and uncertainty (unknown probability distributions). Nonetheless, it is highly argued today that people are highly rational utility maximizers who measure the likely effect of any action on their wealth before deciding. Thanks to the normative theory and the implementation of financial models such as rational decision-making, risk-aversion and uncertainty, the normative theory of decision-making has come under scrutiny.

Making a proper decision involves a trade-off between the risk involve in the decision and the
expected return, no doubt there is a positive shape of both the Security and Capital Market
Lines in Figures 1 and 2 encouraging the fact that investors should be motivated to take

higher risk at least by the promise of a higher expected return although at the same time, this will greatly be determined by the investors' behaviour and attitude towards risk.

As already discussed, most finance theories are based on a number of assumptions of which some include the fact that investors are rational, objective and risk-averse in their behaviour towards risk, and all these come into play in the decision-making process. By being rational implies the reward for an individual's decision is affected by the decisions made by others. Therefore if everything else should remain equal, then all individuals faced with the same situation will make the same decision. Therefore, the optimal choice of the individual is therefore dependent on what they believe others actions are. Cabral 2000 describes this situation as an interdependent decision-making process. Here investors turn to view their actions as being right or wrong depending on the action of others.

The normative decision making theory is of the opinion that individuals try to maximise their utility. This is because, they make economically rational decisions, they can assess outcomes and calculate the alternative paths of these outcomes. This is usually done in a bid of choosing the action that will yield the most preferred outcome.

However, any decision making process is dependent on the individual's attitude and behaviour towards risk with regards to gains and losses. Generally, attitude towards risks when it concerns gains are much more valuable than attitude towards losses. Therefore, making a proper decision involves a trade-off between the risks involve in the decision and the expected return.

Nonetheless, the main assumption of the classical finance school of thought centres on the fact that investors are risk-averse. Risk-aversion is important because it helps us to have a clew as to how investors confront risks and how they behave thereafter. Another assumption of the classical financial theory is that the utility function remains constant overtime and

between situations. As such, if faced with a problem, individual's turn to choose the less risky alternative, at the same level of expected return (Friedman and Sevage 1948), implying therefore that being a risk-averse utility maximizer, investors will turn down any investment option that present a 50/50 lose/gain risk for all initial wealth level (Rabin and Thaler 2000).

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