Human decision-making is known to be largely affected by cognitive biases; that is systematic patterns of deviation from rational thinking swayed by subjective experience and values.
When humans are trying to decide something, they can use two different thinking systems, which are associated with activity in different regions of the brain. The first system is responsible for automatic and learned behaviours, such as driving a car or making quick associations between concepts. The second contributes to reflective, detail-oriented, and slow thinking processes, such as those employed when completing a tax return or writing a report.
Although both systems can be beneficial in different settings, using the first system while making important decisions can result in poor choices and biased considerations. This is because it is guided by ‘heuristics’ , or cognitive shortcuts, which prompt a decision-maker to draw automatic conclusions without considering important details.
As investors and business leaders are often required to make important decisions every day, they should be aware of the cognitive biases that can influence their thought processes and of their far-reaching negative effects. Here are six of the biases that most commonly impact business decision-making, along with some tips and techniques on how to avoid them or mitigate their impact:
1 Loss aversion
This is the tendency to prefer avoiding losses than acquiring gains. Experiments have shown people prefer not to lose £10 than gain £10. Indeed, behavioural scientists have found that the fear of losing something is a powerful driver of human behaviour, often leading to missed opportunities and poor decision-making.
Even when there is a high possibility of gaining from a specific business venture, the fear of losses or other damages could adversely affect a business leader’s decision-making. For instance, the fear of losing capital could prevent stakeholders from investing in a risky business venture that is promising and could in fact be highly advantageous.
A simple strategy to mitigate the effects of this cognitive shortcut is to re-frame a problem, placing greater emphasis on gains than on losses. For example, instead of saying there is a 10 per cent chance that this business venture will fail, one could consider that there is a 90 per cent chance of the venture succeeding.
One of the most robust findings in behavioural science is anchoring, where an initial item of information or a value – the 'anchor' – influences a person's decision.
Studies have found that when people are asked to estimate the price of a product, they tend to respond differently from how they normally would when they are given another person’s guess or estimation first. In other words, when they are given an initial reference value, people tend to stay close to that value, regardless of how absurd it may be.
This bias can have important implications in organisations, particularly in instances where many employees are encouraged to share their opinion or during a team decision-making processes. If a senior or a more assertive employee shares his opinion first, juniors or more reserved employees might be inclined to simply agree with them, even if they have a dissenting opinion.
To avoid this bias, business leaders can employ two different strategies. The first, referred to as ‘consider the opposite’, involves listing both supporting and contrasting evidence for a decision. A common application of this strategy is writing a list of pros and cons, or writing down the evidence supporting or contradicting a specific assumption.
During group meetings, on the other hand, one could encourage constructive debate. For instance, ensuring that juniors and more timid employers are heard first, so that they are not swayed by the opinion of others. Anonymous surveys can also prove valuable, as they encourage respondents to speak their mind and prevent them from influencing each other.
3 Overconfidence bias
People are often guilty of overestimating their ability to make judgements. In business settings, overconfidence could lead managers to hire unsuitable candidates, or employees give unreliable and highly optimistic estimates of how long it will take them to complete tasks.
To mitigate this bias, business leaders could change their recruitment processes and ensure that candidates are blindly evaluated. They could then set employees deadlines based on their past performance on similar tasks.
Another strategy that can help to avoid the overconfidence bias is to ask different opinions and then average them, rather than considering a single expert’s opinion.
In the absence of other expert opinions, a leader could even average out forecasts that they made at different points in time, reflecting on why they changed and considering alternative possibilities.
4 Confirmation bias
We see confirmation bias afflict people all the time, especially on social media. It is where we favour and prioritise information that supports our initial beliefs, assumptions, or values.
An example of this in a business environment could be not recognising the signs that a venture is failing, or that an employee is not performing well, due to a strong underlying belief in their success.
When business leaders are strongly convinced that they made a good investment, they might inadvertently only look for signs of success, ignoring or overlooking issues and shortcomings.
To avoid confirmation biases, leaders could make forecasts using multiple regression and bootstrapping – two renowned statistical methods for making predictions.
Developing simple decision trees that apply to specific situations and using them to make decisions is also a valuable solution, as this will prevent decision-makers from considering irrelevant factors that support their beliefs.
5 Representativeness heuristic
This is a mental shortcut that can lead people to make decisions based on prototypes or representations they have in their mind.
This could mean, for instance, deciding to hire a 30 year-old man with glasses as an accountant, simply because he looks more like a ‘typical accountant’ than other candidates who applied for the same job. It could also mean deciding to invest in a start-up because its attributes resemble those of successful companies, without properly evaluating its potential.
To circumvent the representativeness heuristic, leaders should base their evaluations on relevant data and collect outside perspectives on the problem at hand.
They could also employ a five-step decision-making strategy called ‘reference class forecasting’, which entails:
- Selecting a class of similar projects, candidates or events as a reference
- Plotting the distribution of their outcomes
- Making a prediction about a new project or event while considering how it compares with the reference class
- Assessing the reliability of this prediction
- Correcting the estimate so that it is closer to the reference class’ average performance
6 Default bias
Finally, the default bias is a tendency to remain with the status quo due to a fear of the disadvantages that could come with change.
In organisations, this can translate into a lack of initiative or employees reluctant to ask for a promotion due to the fear of making a mistake or losing their current position.
A highly effective way of mitigating this bias is to encourage employees to make an active choice. For instance, asking them to complete a form expressing their preferences about a new programme they could enrol in or new responsibilities they could take on regardless of whether they wish to do so or not.
Ultimately, cognitive biases can lead to a wide range of poor decisions, such as hiring unsuitable employees or investing large sums of money on a failing or inauspicious business venture.
By implementing the simple strategies outlined above, business leaders could evade these six common biases, strengthening and enhancing their decision making skills.
Liu, C., Vlaev, I., Fang, C., Denrell, J. and Chater, N. (2017) "Strategizing with biases: engineering choice contexts for better decisions using the Mindspace approach", California Management Review, 59, 3, 135-161.
Ivo Vlaev is Professor of Behavioural Science and Advisor for the NHS COVID-19 Behaviour Change Unit. He teaches Behavioural Sciences for the Manager on the Executive MBA and Full-time MBA plus Judgement and Decision Making on the MSc Finance.
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