We like to think our business decision-making process is completely rational. Unfortunately, that’s a delusion. We are prone to thinking errors that are very irrational.
How many times have you done the following?
- Didn’t give up on a losing product or project because you had already invested so much into it you thought you couldn’t give up.
- Trusted your gut to take a chance on something you were certain was going to work, even though you had no evidence that it would.
- Trusted someone based on appearances, rather than researching their credentials and ability.
- Kept believing something would work when the overwhelming evidence said it wouldn’t.
The study of behavioral finance has shown we all consistently fall for business decision-making errors. Our emotions and snap judgments influence our business decision-making process more than we know. In fact, we are more likely to resort to a snap judgment when faced with a complex business decision. The analytical part of our mind can become overwhelmed.
Here are some common business decision-making mistakes and how to overcome them:
Sunk Costs
Sunk costs are costs that have already been incurred but are irrelevant when deciding what to do going forward. Maybe you’ve invested time into a project or money into an investment. You reach a point where you wonder if it’s worth continuing and you think “I’ve put so much into this, I can’t quit now.” That’s the sunk cost fallacy.
The real question to ask is: Will the cost going forward be less than the benefit? If so, then continue. If not, then try to drive the cost down or the revenue up.
I recently talked with a business owner who was selling their business. They wanted to sell their business to cover their investment and debt in the business. I pointed out that those numbers were irrelevant to both them and the buyers. Both needed to value the company on its expected future performance.
This is also an example of anchoring, which I’ll explain next.
Anchoring
Anchoring is starting from one number and then adjusting to another number. This mistake fools even the experts. Daniel Kahneman in Thinking Fast and Slow cites studies that showed real estate agents are almost as influenced by house asking prices as business students with no real estate experience.
Negotiations are where you will need to be very careful of anchoring. Some say to force the other party to make the first offer in negotiations. The power of anchoring questions that logic. The first number introduced becomes the anchor, or starting point, of all future negotiations. Both sides do this unconsciously.
How many times have you heard something like this on an infomercial “How much would you pay for all this? You could pay $1,000 but today you can get it for only $49.” The first number creates an anchor.
How powerful is anchoring? A completely unrelated number to the price in a negotiation could serve as the anchor.
Studies have shown that introducing random numbers like telephone numbers or a social security number can influence the outcome of the decision. Kahneman also cites a study where students spun a wheel of numbers. The number selected by the wheel influenced their answer to the number of African nations in the UN.
Our minds struggle to free ourselves from the starting number to make our decision. Beware of all numbers in a negotiation that could be the anchor that sinks you.
How can we counteract the power influence of anchoring? Let’s assume the person you are negotiating with starts with an outrageous number. Kahneman lists a couple of options in Thinking Fast and Slow:
- Suspend the negotiation “and make it clear – to yourself as well as the other side – that you will not continue the negotiation with that number on the table.”
- Focus your attention on arguments against the anchor.
Unrealistic Optimism
Is there a two-word phrase that better describes how so many people become small business owners? Optimism drives motivation but when we’re unrealistic we quickly drive to a dead-end.
John Nofsinger in his book, The Psychology of Investing, cites a study where new business owners thought they had a 70% chance of success. Only 39% of those owners thought any business like theirs would succeed. Most new businesses fail. He then rhetorically asks “Why do new business owners think they have nearly twice the chance of success as others? They are overconfident.”
Unrealistic optimism isn’t limited to small business owners. Most people are optimistic. We all like to think we are better drivers than average, smarter than average, or funnier than average. While most believe this, this can only be true for half of us.
Optimism is a powerful force that allows us to reach for opportunities and take chances. I don’t want to deter you from that. They key to this is unrealistic optimism.
Carefully assess the objective grounds for your optimism. Crunch the numbers when business decision-making. Your gut reaction and feelings of optimism have to be matched with a series of facts. You may be optimistic that you can fly but you can’t fight gravity.
Patterns and Extrapolation
It’s the fable of the baseball player on a hitting streak or the basketball player with the hot hand. You’re certain you can detect a pattern. Statisticians have proven that these athletes have no above-normal chance of continuing their streak.
Our minds are constantly scanning for order in a very random world. When we detect the pattern, we think we’ve found insights that could make us rich. Whether it’s stock patterns or sales charts, we must be very careful before believing we’ve found a pattern.
A similar error is called the extrapolation bias. We see a pattern and assume that the pattern in the past is going to continue in the future. This may be true but it’s not certain.
I saw this all the time with business customers when I worked in banking. Rates would start rising and customers would expect continued rising rates. They would be more willing to lock in a long-term high rate now rather than risk future higher rates. If the economy was poor, they expected future poor economic conditions.
The trend might continue. Assuming so made them blind to seeing how to position themselves for when the trend reversed.
One way for you to fight the power of perceived patterns is to challenge the pattern when it’s based on a small number of data points. Just a couple of bad months is not enough to declare a much larger trend.
Another technique is to repeat the phrase you see so often in investment literature: “Past performance does not guarantee future results.” Challenge the recent pattern by remembering times in the past when that pattern reversed. Admitting the possibility of a change in the pattern will open your mind to new options.
Representativeness
This is the belief that “A” is like “B” based on by how much “A” resembles “B”, regardless of the true probability that they are related. We make snap judgments like this all the time.
We look at a person or a place and instantly determine if it looks like a place or person we can trust or one we can’t. This may be made purely by representativeness and not by the true investigation into its trustworthiness.
Let’s say we meet a well-dressed person who speaks persuasively about an investment. A recent set of ads for the Certified Financial Planner Board shows a well-groomed advisor guiding a couple with their investments. The couple clearly trusts the advisor.
The advisor then reveals that they are a tattoo artist or some other occupation that has nothing to do with investments. We are then shown a picture of the “advisor” before the makeup people groomed them to look like an advisor. The “before” picture showed someone you wouldn’t have easily trusted with your investments.
How do we make a clear-minded decision to invest our company’s scarce cash? Write down all the pros and cons of the investment. Give it to someone else you trust to give you their thoughts.
Set the decision aside and come back to it later when you are less emotionally involved. Is the investment just as compelling without the sheen of the salesperson?
We can look at this both by how we perceive others and how others may perceive us. For better or worse, your customers make the same representative snap judgments about you. Style matters. It’s hard work to overcome a bad first impression that caused you to be classified as untrustworthy or not very valuable.
Availability Bias
We have the tendency to think something is more expected or common when it’s easier to think of examples. I’m prone to thinking that I’m more likely to contract a disease after I’ve just read about it on the internet. People are more nervous about flying after news of a plane crash.
The availability bias proves the adage that we are what we think we are. If the first thoughts available to us are failure we think we are more likely to fail.
The bias can also compound overconfidence when we’ve had recent successes or have seen successes in others that we identify with. We are more likely to believe we will be successful, which causes us to be overconfident and take risks.
Once again, don’t just trust your “gut” (or your easily fooled mind) and do the research to determine if it’s true or not. As Daniel Kahneman said in Thinking Fast and Slow: ”high confidence mainly tell[s] you that an individual has constructed a coherent story in his mind, not that the story is true.”
Confirmation Bias
The solution to many of the errors above is checking our facts to separate the truth from beliefs. Sadly, even our minds thwart our efforts to find “the truth.” We are selective in the facts we accept as truth. We select the facts that confirm what we already believe. This is the confirmation bias.
A way to defend from the confirmation bias is by using the thought process of a “devil’s advocate.” If your bias is for success, improve your business decision-making process by considering ‘why we should not do this’ or ‘what could go wrong’. You can do this process yourself. It can be more effective to find someone else to act in the role of ‘devil’s advocate’ to argue against your bias.
Be careful, because using someone else might further entrench your beliefs. This happens when you already feel strongly about a course of action. The argument of the “devil’s advocate” will only be countered in your mind with your beliefs, making those beliefs stronger.
Are You Done Making These Business Decision-Making Mistakes?
Being aware of business decision-making mistakes is half the battle of avoiding their harm. The other half of winning the battle is using the steps above to not succumb to them.
You can do many of the techniques above yourself, but confirmation bias might foil those attempts. Sometimes the perspective of a peer or coach provides better clarity. They help you see your thinking errors. Talking with others:
- Helps you create and crystalize ideas. It may cause you to use other parts of your brain that when you are just thinking about the decision.
- Introduces viewpoints of people that aren’t as emotionally involved with the decision.
- Allows someone who may have more experience to guide you.
- Brings in “fresh minds”. Decision-making is tough work and you may be so tired from the process that you aren’t thinking your best.
So many people are blind to these thinking errors but now you not only can be more aware of them, you know how to overcome them. Learn more ways to improve your decision skills with my behavioral finance program.
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