My first article on this topic, Biased, Me? Minimizing the Impact of Cognitive Biases, received a lot of positive feedback. (Thank you!) Several readers asked about other biases that can negatively impact our business lives. So this time around, I want to look at ones that affect how we perceive value and in turn influence how we invest our resources.
First, though, let me define cognitive bias for anyone unfamiliar with the term. They are mental shortcuts that our brains take in order to be able to process the vast quantities of information that confront us each day. Also known as heuristics by psychologists, cognitive biases help us make decisions more quickly. Unfortunately, the perceptions shaped by such patterns of thinking often don’t accurately reflect reality. Cognitive bias can cause us to place undue importance on some information while dismissing other facts that could help us form more accurate judgments.
We’ve previously discussed the Endowment Effect, which describes the tendency to attribute worth to things we own with little regard for their objective market value; but there are many more “economic” cognitive biases. Here are 5 that can lead us to make poor business decisions that waste our companies’ valuable time and money.
If you’ve ever watched an infomercial, you’re already familiar with the Anchoring Bias – although you may not know it by that name. It describes our tendency to allow the initial price we see for an item or service to affect our perception of any prices offered later. It’s why infomercials stress the high-dollar value of the items you’ll receive early in the pitch. By anchoring you to that initial high number, the price you’re eventually asked to pay seems more reasonable. This remains true, regardless of the actual market value of the goods.
While it may be tempting to play into this bias, be careful! When consumers realize they’ve been manipulated, the backlash can be considerable. And, of course, we want to avoid falling into this cognitive trap when it comes to our own purchasing behavior.
No matter which name you use for it – and there are several – this bias is why we often opt for a smaller payoff now when we could receive a greater reward at a later date. Some people dismiss such decisions as “childish” behavior. While it’s true that the ability to delay gratification is a skill most people develop in early childhood, a wide range of factors influences our ability to do so consistently. Some of these, such as impulsiveness, are strongly influenced by genetics and epigenetics. Of course, it doesn’t help that numerous influences in our daily lives from the dopamine hits we get from social media to the gamification of workplace culture conspire to erode our ability to wait for rewards.
When it comes to business management, Delay Discounting can have a profound negative impact. It can hamper the ability to develop and execute effective growth strategies. Additionally, it often contributes to staff turnover and the resulting institutional knowledge loss.
Sunk Cost Fallacy
Ever heard the old expression, “throwing good money after bad”? That’s the Sunk Cost Fallacy, sometimes referred to as Post-Purchase Rationalization, in a nutshell. It describes the tendency to invest more time and money in a failing project in hopes of turning things around. Of course, the more resources we devote to such projects, the harder it can be to admit the initial poor decision and walk away … poorer, but wiser.
Obviously, any business can find itself going down the wrong path from time to time. But when decision-making power is concentrated in the hands of a single person or small group, the impact of this fallacy is magnified. This is especially true if decision-makers are strong-willed visionaries, as many entrepreneurs are. The same thing can happen when a workplace culture of fear exists that prevents or punishes employees for giving honest feedback about projects.
Like the Sunk Cost Fallacy, the Gambler’s Fallacy deals with trying to turn a bad trend around. It describes the tendency to believe that past events influence the likelihood of future outcomes. If you’ve ever heard someone say, “This has to work. We’re due for a win”, you’ve witnessed this fallacy in action.
There are numerous factors that can determine the success or failure of any particular course of action: timing, knowledge and skill, financial resources, strategic focus and leadership, operational effectiveness, etc. It can be argued that good fortune plays a role, but past outcomes don’t. Sorry, but Lady Luck doesn’t owe you a thing. That’s good news, though. Imagine if a string of successes led inevitably to a stunning failure because it was due!
The last of these economic cognitive biases also concerns risk-taking behavior. All businesses try to avoid failures and economic losses, of course. The Loss Aversion bias, however, leads us to have a stronger emotional response to a loss than we do to an equivalent gain. In its most extreme form, even a perceived loss can be devastating. For example, a $10,000 “loss” from a deal that falls through receives far more attention than the $10,000 earned from helping a long-term client.
When the fear of loss becomes the overwhelming factor in the decision-making process, growth and innovation stall. Additionally, consistently discounting successes has a toxic effect on team morale. It can also impact current and prospective clients’ expectations for a business.
Ways to Minimize the Economic Impact of Cognitive Biases
The first step to overcoming any cognitive bias is recognizing that we have one. Because they often operate at a subconscious level, this can be extremely challenging. (You can check out the previous article for tips on overcoming cognitive bias.) When it comes to biases that affect the bottom line, though, there are specific steps that businesses can take to minimize their impact.
A procurement strategy that requires competitive bids helps employees more accurately value goods and services. Just be careful not to anchor too strongly on the first bid received! A robust budgeting and project management process that tracks the actual expenses involved, including people’s time, provides the data needed to combat the Sunk Cost Fallacy.
Distributing decision-making authority throughout the organization limits the influence of any individual’s ego or fears. A healthy workplace culture that encourages employees at every level to ask questions and offer suggestions also serves as a checks-and-balances on leadership. It’s also a great practice to intentionally assess outcomes to determine the root causes of both successes and failures. Tracking these factors over time helps avoid the Gambler’s Fallacy. It also engenders a more data-driven approach to strategic planning overall.