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The theoretical models that inform national and global macroeconomic decisions are built on a fallacy – that human beings are rational. You and I know better. There is no perfectly rational human. Each person’s subjectivity, informed by her scrapbook of experiences, creates her unique perception of the world. But behavioural psychologists have observed patterns in our irrational actions and found the common causes – they call these, cognitive biases.
Cognitive biases inhibit our ability to make rational decisions. This is due to the inherent difficulty in understanding concepts that differ from our direct experience – things like statistical significance, exponential change and the present value of money.
Rational decision-making is desirable in a business context. It allows us to make more measured investment decisions and to allocate risk based on evidence rather than feeling.
To move towards a more rational decision-making process, we need to both understand cognitive biases and recalibrate our minds and our environments to compensate for them.
This article explores how cognitive biases lead to sub-optimal business decisions and suggests ways to combat or use them to your advantage.
But First, Some Theory
Most decisions contemplate parting with current resources (usually time or money) in the hope of creating a future outcome or event. Choosing between options (which resources to part with) requires an understanding of the relative value and likelihood of future events.
A rational agent would compare potential future events by multiplying the value to herself if an event were to occur by the probability that it will occur. For example, an outcome that, if achieved, would return $100 and which has a 25% chance of occurring has an expected payoff of $25. The agent would then choose the course of action with the largest expected payoff.
An irrational agent (you and me) cannot see things so clearly. Her inherent biases warp her perception of both probability and value. She values immediate events more than remote ones (a phenomenon called, Hyperbolic Discounting) and she thinks future events that are similar to recent past events are more probable (the Gambler’s Fallacy). Due to these biases and others, she misjudges the rational expected payoff of future events and makes irrational decisions.
Investment Decisions (Time or Money)
Investment decisions are perhaps the most susceptible to the negative effects of cognitive biases. And the potential loss from a poor decision is large – the misallocation of hours of your team’s time or hard-won investment budget.
The tendency to favour information that affirms our preconceptions. Or, as is more common in the workplace, the tendency to ignore or discount information that contradicts existing beliefs. This is often perceived as stubbornness and can harm team relations as well as lead to poorer decisions.
How to beat it
Try the exercise of arguing the position that is the opposite of your initial or natural view. Trying to convince yourself of an alternative position will encourage you to genuinely engage with data that you may have subconsciously overlooked due to Confirmation Bias. At the very least, it will help you to understand another point of view.
We believe that losses hurt more than gains feel good. This leads most of us to seek to avoid losing money more intently than generating new money. It also applies to time. We exert more effort protecting the existing free time in our calendars than liberating time already tied up in meetings.
How to use it
Try this the next time you run a short-term incentive program (for example, a week-long competition between sales team members).
Rather than offering a reward for team members achieving a target, hand over the reward up front and then warn the team that you will claw back the reward if the same target is not met. Loss Aversion suggests that your team will fight harder to keep the reward than they would have to earn it in the first place.Continue reading this article below the form
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Cognitive biases distort the way we perceive information. Verbal and written communications – between team members and with clients – are no exception. Understanding how irrational agents (remember, that’s all of us) interpret words and actions can help us to communicate clearly and persuasively.
The tendency to favour the first piece of information we receive. Whenever your audience appears fixated on a previous statement or belief, this could be due to Anchoring Bias. It hampers a communicator’s ability to convey new ideas or alternative perspectives.
How to use it
Management consultants talk about ‘anchoring the discussion’. This involves providing an easily-accepted fact or belief from which to draw logical conclusions or analogies.
Try anchoring your meetings and emails with recognisable data – such as the company’s progress versus its growth target – then use this as a starting point to make your argument. Your conclusions may carry more weight.
The tendency to seek information when it does not affect action. It’s a common stall tactic in corporate politics – order another report. And often it can seem like the right thing to do- making a decision with insufficient information is clearly imprudent.
How to beat it
Avoid “analysis paralysis” by asking these three questions before seeking new information:
- What action could the new information potentially impact?
- How could the new information impact the action? (e.g., could the new information potentially reverse the decision to take action?)
- Is the new information likely to have an impact on the action?
When information is sought deliberately to prove or disprove an action-oriented hypothesis, it is more likely to be useful to the business.
Reflection and Evaluation
We’ve seen how our biases can alter our perception of the future (investment decisions) and the present (communication). The past is certainly not immune from the taint of irrationality!
When we reflect on past actions, we judge them based on current information. This obscures our ability to climb into the shoes of past decision-makers and to learn from their successes and failures.
The tendency to judge a decision based on its outcome. We celebrate victories where chance played a deciding role in the outcome. Likewise, we condemn failures even when, if faced with the same situation again, we would make the same decision. Further, we consider the reasoning behind a decision with a positive outcome to be more sound than when the outcome is negative.
How to beat it
Review and reward your team’s work based on the effort and process that informs their decisions as well as their outcomes. Compensation and reward schemes that only take into account the bottom line fail to incentivise sound decision-making processes, which are necessary for consistently good decisions.
The tendency to interpret past events through present knowledge or beliefs. Judging the decisions of our past selves (and teams) often leads to an over-critical assessment in light of information that was unavailable at the time. This can lead to unnecessarily harsh evaluations.
How to use it
Use Hindsight Bias to reflect on the information flows in your business. Try to specifically identify the new information that caused you to view your past decision unfavourably. Was the information available to you? If so, why didn’t you take account of it? If not, how can you make such valuable information available next time?
Unconscious biases can cause us to draw incorrect conclusions. To think that, even with perfectly accurate information (a very unlikely state of affairs), we still draw incorrect conclusions – that’s scary. We’ll never be perfectly rational agents. But recognising and recalibrating to adjust for our common, inherent biases is the first step to mastering them.
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