While making critical decisions, not many strategists are conscious of the impact that cognitive biases have on business decisions. These biases are part of human behavior, and can be referred to as “systematic human tendencies to deviate from rational calculations.”
In strategic decision making, leaders need to recognize their own biases, as these biases influence important strategic decisions made by the smartest managers in the best companies. Understanding these biases is also foundational to behavioral economics. Two broad categories of biases cause the people to drift from rational decision-making:
- Emotional Biases
- Cognitive Biases
Emotional biases entail taking action on feelings instead of fact, or making emotionally driven decisions rather than logical ones—i.e., a person’s inclination to believe in something that has a positive emotional effect or that gives a pleasant feeling, even if evidence contradicts it. Cognitive biases, on the other hand, arise due to incomplete information or the inability to analyze the available data. These preconceived notions can be categorized as either Belief Persistence or Processing Errors. Belief Persistence occurs when individuals try to shun the conflict in mind that occurs when facts contradict their existing beliefs. Processing errors occur due to failure in organizing and analyzing data properly.
The awareness and the ability to manage cognitive biases assists the decision makers in making more logical decisions. The following are the 9 most common Cognitive Biases that occur most frequently and have the largest impact on business decisions:
- Conservatism Bias
- Base Rate Neglect
- Confirmation Bias
- Sample Size Neglect
- Hindsight Bias
- Anchoring and Adjustment
- Mental Accounting
- Availability Bias
- Framing Bias
- Conservatism Bias: This happens when people give more importance to pre-existing (archived) information over new data. New information should be cautiously evaluated to determine its value prior to reaching a business decision.
- Base Rate Neglect: The exact opposite of conservatism bias, in Base Rate Neglect people prefer new information over original information. For instance, if given related general information and specific data, the mind tends to ignore the former and favor the latter.
- Confirmation Bias: This occurs when we fail to search impartially for evidence—overweigh evidence consistent with our existing beliefs while ignore the one that is against a favored belief.
- Sample Size Neglect: An error that occurs when an individual infers too much from a very small sample size or information. In order to make meaningful statistical inference from a data set, the sample size must be large enough to be significant.
- Hindsight Bias: The tendency of people to overrate their ability to forecast an outcome that could not possibly have been predicted. This occurs when people identify actual outcomes as expected, but only after the fact.
- Anchoring and Adjustment: An error caused when a specific target number or value is used as a starting point—the anchor—and then adjustments are made until an acceptable value is reached.
- Mental Accounting: A set of cognitive operations used by individuals to arrange and keep track of financial activities. They earmark certain funds for certain goals and keep them separate. Individuals are likely to make illogical decisions in their spending and investment behavior.
- Availability Bias: The phenomenon where decision makers give preference to information and events that are more recent. Availability bias distorts perceived future probabilities based on notable past events.
- Framing Bias: A tendency to process the same information differently depending on how it is presented. Individuals make a certain decision if an option is presented in terms of loss, but decide otherwise if the same option is stated in terms of profit.
Experienced executives are able to discern biases and make allowances for those—by applying a discount factor—to adjust for someone’s over-optimism or seek neutral opinion to avoid biased suggestions. But, at times, these adjustments are also inaccurate. These biases in corporate decisions are a product of behavior, training, culture, and human nature.
A global McKinsey study conducted in 2009 about the quality of executive judgment and decision making revealed that out of the 2,207 executives only 28% considered the quality of strategic decision making in their organizations to be satisfactory. About 60% of the participants believed that bad decisions were just as likely as good ones, while rest of the 12% thought that good decisions were rare in their companies.
Sound judgment and strategic decision making necessitates 3 key elements:
- Gathering facts and analysis
- Perceptions and judgments of executives (company or industry variables)
- A thorough decision making process
Better strategic decisions necessitate attempts at limiting our biases as well as establishing a decision making process that can challenge various biases and minimize their effect. The process for strategic decision making requires an understanding of the 5 Building Blocks of Behavioral Strategy to help nullify biases:
- Counter Pattern Recognition Biases by Reframing the Perspective
- Counter Action-oriented Biases by Recognizing Uncertainty
- Counter Stability Biases by Changing Things Up
- Counter Interest Biases by Making Them Explicit
- Counter Social Biases by Depersonalizing Discussions
Interested in knowing more about how these 5 Building Blocks of Behavioral Strategy provide useful practices to neutralize biases and help ensure unbiased decision making? You can learn more and download an editable PowerPoint about the Building Blocks of Behavioral Strategy here on the Flevy documents marketplace.