Decision Biases

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In reality, decision making is not rational because there are limits on our ability to collect and process information. Because of these limitations, Nobel Prize-winner Herbert Simon argued that we can learn more by examining scenarios where individuals deviate from the ideal. These decision biases provide clues to why individuals such as CEOs make decisions that in retrospect often seem very illogical— especially when they lead to actions that damage the firm and its performance. A number of the most common biases with the potential to affect business decision making are discussed next.

Anchoring and adjustment bias occurs when individuals react to arbitrary or irrelevant numbers when setting financial or other numerical targets. For example, it is tempting for college graduates to compare their starting salaries at their first career job to the wages earned at jobs used to fund school. Comparisons to siblings, friends, parents, and others with different majors are also very tempting while being generally irrelevant. Instead, research the average starting salary for your background, experience, and other relevant characteristics to get a true gauge. This bias could undermine firm performance if executives make decisions about the potential value of a merger or acquisition by making comparisons to previous deals rather than based on a realistic and careful study of a move’s profit potential ("Decision Biases" [Image missing in original]).

The availability bias occurs when more readily available information is incorrectly assessed to also be more likely. For example, research shows that most people think that auto accidents cause more deaths than stomach cancer because auto accidents are reported more in the media than deaths by stomach cancer at a rate of more than 100 to 1. This bias could cause trouble for executives if they focus on readily available information such as their own firm’s performance figures but fail to collect meaningful data on their competitors or industry trends that suggest the need for a potential change in strategic direction.

The idea of “throwing good money after bad” illustrates the bias of escalation of commitment, when individuals continue on a failing course of action even after it becomes clear that this may be a poor path to follow. This can be regularly seen at Vegas casinos when individuals think the next coin must be more likely to hit the jackpot at the slots. The concept of escalation of commitment was chronicled in the 1990 book Barbarians at the Gate: The Rise and Fall of RJR Nabisco. The book follows the buyout of RJR

Nabisco and the bidding war that took place between then CEO of RJR Nabisco F. Ross Johnson and leverage buyout pioneers Henry Kravis and George Roberts. The result of the bidding war was an extremely high sales price of the company that resulted in significant debt for the new owners. comedian W. C. Fields once advised, “If at first you don’t succeed, try, try again. Then quit. There’s no point being a damn fool about it.”

Figure 10.6 Providing an excellent suggestion to avoid a nonrational escalation of commitment, old school  

  

 

Fundamental attribution error occurs when good outcomes are attributed to personal characteristics but undesirable outcomes are attributed to external circumstances. Many professors lament a common scenario that, when a student does well on a test, it’s attributed to intelligence. But when a student performs poorly, the result is attributed to an unfair test or lack of adequate teaching based on the professor. In a similar vein, some CEOs are quick to take credit when their firm performs well, but often attribute poor performance to external factors such as the state of the economy.

Hindsight bias occurs when mistakes seem obvious after they have already occurred. This bias is often seen when second-guessing failed plays on the football field and is so closely associated with watching National Football League games on Sunday that the phrase Monday morning quarterback is a part of our business and sports vernacular. The decline of firms such as Kodak as victims to the increasing popularity of digital cameras may seem obvious in retrospect. It is easy to overlook the poor quality of early digital technology and to dismiss any notion that Kodak executives had good reason not to view this new technology as a significant competitive threat when digital cameras were first introduced to the market.

Judgments about correlation and causality can lead to problems when individuals make inaccurate attributions about the causes of events. Three things are necessary to determine cause—or why one element affects another. For example, understanding how marketing spending affects firm performance involves (1) correlation (do sales increase when marketing increases), (2) temporal order (does marketing spending occur before sales increase), and (3) ruling out other potential causes (is something else causing sales to increase: better products, more employees, a recession, a competitor went bankrupt, etc.). The first two items can be tracked easily, but the third is almost impossible to isolate because there are always so many changing factors. In economics, the expression ceteris paribus (all things being equal or constant) is the basis of many economic models; unfortunately, the only constant in reality is change. Of course, just because determining causality is difficult and often inconclusive does not mean that firms should be slow to take strategic action. As the old business saying goes, “We know we always waste half of our marketing budget, we just don’t know which half.”

Misunderstandings about sampling may occur when individuals draw broad conclusions from small sets of observations instead of more reliable sources of information derived from large, randomly drawn samples. Many CEOs have been known to make major financial decisions based on their own instincts rather than on careful number crunching.

Overconfidence bias occurs when individuals are more confident in their abilities to predict an event than logic suggests is actually possible. For example, two-thirds of lawyers in civil cases believe their side will emerge victorious. But as the famed Yankees player/manager Yogi Berra once noted, “It’s hard to make predictions, especially about the future.” Such overconfidence is common in CEOs that have had success in the past and who often rely on their own intuition rather than on hard data and market research.

Representativeness bias occurs when managers use stereotypes of similar occurrences when making judgments or decisions. In some cases, managers may draw from previous experiences to make good decisions when changes in the environment occur. In other cases, representativeness can lead to discriminatory behaviors that may be both unethical and illegal.

Framing bias occurs when the way information is presented alters the decision an individual will make. Poor framing frequently occurs in companies because employees are often reluctant to bring bad news to CEOs. To avoid an unpleasant message, they might be tempted to frame information in a more positive light than reality, knowing that individuals react differently to news that a glass is half empty versus half full.

Satisficing occurs when individuals settle for the first acceptable alternative instead of seeking the best possible (optimal) decision. While this bias might actually be desirable when others are waiting behind you at a vending machine, research shows that CEOs commonly satisfice with major decisions such as mergers and takeovers.