The decision-making process of human beings, and specifically economic agents and managers, has been a fruitful subject of popular psychology. An impressive body of literature has been produced to date on this important question: “Which mistakes does a human being –and therefore every manager– make when he attempts to take rational business decisions?”
Psychologists will categorize most of these mistakes as cognitive biases. As usual, I have been going through endless pages of literature (and Wikipedia) and condensed the most important items in here. For further reading, I happily recommend the book “Irrationality” by Stuart Sutherland. One final remark before we kick this off: it is a very common mistake to read this and to think you are not committing these errors yourself. Wrong again…
- Optimism bias: all of us have the tendency to overestimate the positive outcome of our plans and actions. This is demonstrated and has huge effects in business life. Higher risks are taken, paybacks are estimated to be higher or earlier, costs are less controlled.
- Loss aversion (future potential loss vs. future potential gain). Whenever given the choice between a future certain payout and a future probable payout which is higher, people will consistently choose for the first. When given the choice between a future certain loss and a probable, but higher, future loss, they will go for the second. Also, the “utility”, which is the value that a user associates to a certain amount, will be perceived higher when something is lost than when the same is gained. We feel more regret about losing 100$ than that we feel joy about finding 100$. Schematically:
Loss aversion Objective Utility Perceived Utility Certain loss 100$ = – – 33% chance of 300$ loss = – Certain gain 100$ = + + 33% chance of 300$ gain = + Loss of 100$ – – – Gain of 100$ + +
- Strategic misrepresentation. Is a rather fancy name for lying in the budget. Given the way most managers are incentivised, it should come as no surprise they are willing to go great lengths to misrepresent facts and plans. “Sandbagging” is related to this: a manager knows the cost structure of his part of the organization better than anyone else. He can easily defend the necessity of costs while in fact they will never be made and merely serve to lower his bonus goals.
- Illusion of control: we all overestimate our control over events that cannot be influenced, or not to the extent we would like to believe. Both believe in the paranormal and gambling are great examples. In business, traders in investment banks have been demonstrated their performance is impacted by this bias.
- Semmelweiss reflex: the reflex-like reaction of rejection that most people have when confronted with a new piece of information that contradicts their existing paradigm. An important factor is the fact that this happens without thinking or critical reasoning. We are all prone to get in denial when confronted with obvious, but different-than-expected knowledge. Related to this is confirmation bias, where people readily accept any evidence that confirms their pre-existing beliefs. What can also be seen is that ambiguous evidence is happily curbed towards the receiver’s expectations.
Within the next days I will publish the next 5, thereby briefly touching on things like groupthink and sunk costs… hope you like it!