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In their article, The Hidden Traps in Decision Making, authors John S. Hammond, Ralph L Keeney, and Howard Raiffa introduce six common, yet often disguised, psychological pitfalls that every decision maker faces when contemplating an important choice. These hidden traps include:

•The Anchoring Trap
•The Status-Quo Trap
•The Sunk-Cost Trap
•The Confirming-Evidence Trap
•The Framing Trap
•The Estimating and Forecasting Traps (Hammond, Keeney & Raiffa, 2006)

According to Hammond, Keeney, and Raiffa, decision makers are particularly susceptible to estimating and forecasting traps- those involving uncertainty – because most of us aren’t proficient at judging chances. “We are adept at judging time, distance, weight, and volume,” the Authors explain, “because we’re constantly making judgments about these variables and getting quick feedback about their accuracy. Through daily practice, our minds become finely calibrated. Judging uncertainty, however, is a different matter. Though we often make forecasts about uncertain events, we rarely get clear feedback about our accuracy” (Hammond, Keeney & Raïffa, 2002 p.213). Gilboa offers the example of a roulette wheel which has come up “black” that last five spins. Given a choice, he states that many respondents would now rather bet on “red” as the result of the next spin. There is no logical answer as to why individuals subscribe to this “Gambler’s Fallacy”, though Gilboa tends towards an over-interpretation of the law of large numbers as the rationale. As he explains it, the law states that, “if you observe a long sequence of Independent and identically distributed random variables, their average will, with very high probability, be very close to their (joint) expectation. Thus, if the roulette wheel is indeed fair, then, as the number of spins goes to infinity, the relative frequency of “red” and of “black” will converge to the same number” (Gilboa, 2010 p.74). Simply put, if one observes five “blacks” and no “reds”, the mind rationalizes that red must “catch up”. This expectation is, of course, false, as nature cares little about correcting any perceived bias or deviations from the expected frequency. As Hammond, Keeney, and Raiffa put it, “despite our innate desire to see patterns, random phenomena remain just that random” (Hammond, Keeney & Raïffa, 2002 p.211).

If one considers Professor Zlatev’s discussion of the foundations of strategic decision making and his statement that, “uncertainty limits the ability of a given organization to control the outcomes of its strategic decisions” (Zlatev, 2013), then one must be concerned with Hammond, Keeney, and Raiffa’s contention that individual’s struggle to make decisions when confronted with uncertainty. For instance, consider an organization principally involved in a technology-based service, has been providing the service for many years, and is considered an expert in the field. The organization has evaluated new technology entering the market and, ultimately, fails in implementing a strategy involving this technology because decision-makers underestimate the impact it would have on the industry. The decision not to adopt the new technology is based on several factors, including the reliability and performance of current technology and the fact that the company possesses a high level of comfort with existing methods. These factors influenced leadership to ignore emerging trends, thus assuming consumer’s tastes would reflect their own. In attempting to make strategic decisions about the company’s future, the decision-makers misjudged the distance between where they were as an organization at the time and where they wanted to be. It is clear from the outcome of this failed strategy that, in order to make effective decisions, one must be predictive, not reactive. As Taylor states in his examination of adaptable, analytic systems designed to handle changing circumstances and allow for continuous process improvement, “passing only historical data into a Decision Management System would be like driving with only the rear view mirror—every decision being made would be based on out-of date and backward-looking data” (Taylor, 2011 p.61).

Gilboa, I. (2010). Making better decisions: Decision theory in practice. (1 ed.). Wiley-Blackwell.

Hammond, J. S., Keeney, R. L., & Raïffa, H. (2002). Smart choices, a practical guide to making better life decisions. Broadway.

Hammond, J. S., Keeney, R. L. & Raiffa, H. (2006, January). The hidden traps in decision making. harvard business review, Retrieved from http://hbr.org/2006/01/the-hidden-traps-in-decision-making/ar/1

Taylor, J. (2011). Decision management systems: A practical guide to using business rules and predictive analytics. IBM Press.

Zlatev, V. (2013, March). Lecture 04 – strategic decision making in organizations. Lecture Retrieved from https://onlinecampus.bu.edu/webapps/portal/frameset.jsp?tab_group=courses&url=/webapps/blackboard/execute/displayLearningUnit?course_id=_5747_1&content_id=_843891_1&framesetWrapped=true

Short-term debt, commonly known as current liabilities, are obligations that are expected to require cash payment within one year or within the operating cycle, whichever is shorter (Ross, Westerfield & Jaffe, 2010 p.747). Short-term debt funding can be either matched or unmatched: matched funding indicates the term of the debt matches the term of a project for which the funds are being raised or, in cases of unmatched funding, the duration and maturity of the debt does not coincide with a funding requirement for a specific project. In most cases, firms want funding to match in order to ensure that funds are available for long-term projects and capital. This method precludes the necessity of having to refinance at some period well before project completion; the risk being that lenders might not be willing to provide new loans. There are some circumstances, however, in which the matching principle would be disregarded. Particularly, “in some debt markets, opportunities may arise only occasionally to borrow at an attractive rate or for a particular maturity. These opportunities should be taken when available, because they might not be there when the funds are eventually needed” (Coyle, 2000 p.46). In other instances, small companies often find it unfeasible to adhere to the matching principle because of their well-known difficulties raising long-term capital. This leads us to the discussion of the somewhat unorthodox method of utilizing short-term debt to finance long-term capital. This method may be desirable, especially during periods of economic downturn, because of the readily availability of short-term debt and the fact that it provides an easy way to reduce financing costs. Also, the short-term debt available at variable interest rates determined by the market makes it an attractive option.

There are important questions that arise for firms when using of short-term debt in this manner. Viscione states that, “perfect matching is not essential. The important questions are: How much risk is involved, and when does the risk become excessive? The answers depend on the extent of mismatching, the way financings are structured and managed, and the particular circumstances—like the operating risks—of the business” (Viscione, 1986). The risks that firms face include the fact that interest rates may be higher when the loan is due for renewal or that the lender may choose to terminate the arrangement all-together. Viscione also points out the real possibility of loss of operating autonomy: the lender may not terminate the arrangement, but may use it as leverage to direct the firm in painful or unpleasant directions. “They may even insist on revised terms,” Viscione indicates, “such as more security, personal guarantees, or higher charges. For the unhappy owner of the business, the deterioration of the relationship with the lender, signaled by the change in terms, could not come at a worse time” (Viscione, 1986). Cheng and Milbradt concur, citing a model of a nonbank financial firm they constructed and analyzed that faces rollover externalities because of the use of staggered short-term debt during a period of financial crisis like that which the US faced over the last decade. Under this view, according to the authors, short-term debt creates a liability-side risk, or funding risk, for firms, necessitating a moderate amount of emergency financing —what they term a “bailout”— to be available. The authors’ primary conclusions are, “that debt can be too short-term, covenants that constrain managerial actions should be avoided, and bailouts can improve creditor confidence” (Cheng & Milbradt, 2012 P.1097).

In terms of practical application, one can attempt to apply this methodology to a situation involving an organization’s need to make capital investment during the height of the recent financial crisis. A piece of equipment reached end-of-life status and the OEM’s service contract on the equipment became limited. An organization is faced with the relative obsolescence of the technology in the face of more advanced equipment being utilized. Preparations to purchase new equipment were underway in advance of the end-of-service life situation; however, at its height, lending institutions became conservative and financing was unavailable. One option available was to seek out an equity firms’ backing in an attempt to secure funds. However, the organization realized the vetting process would be long and drawn out, jeopardizing its ability to take advantage of the Original Equipment Manufacturer’s low purchase price on a new piece of equipment. The question becomes whether the organization should have sought out a short term debt solution in order to finance the purchase of the new equipment, thus making it’s competitive advantage in the marketplace appear more attractive in the eyes of equity firms?

Cheng, I., & Milbradt, K. (2012). The hazards of debt: Rollover freezes, incentives, and bailouts. Review of Financial Studies, 25(4), 1070-1110.

Coyle, B. (2000). Capital structuring: Corporate finance. Global Professional Publishing.

Ross, S. A., Westerfield, R. W., & Jaffe, J. F. (2010). Corporate finance, 9/e. New York City: McGraw-Hill/Irwin.

Viscione, J. A. (1986, March). How long should you borrow short term?. Harvard Business Review, Retrieved from http://hbr.org/1986/03/how-long-should-you-borrow-short-term/ar/1