Avoiding traps in strategic decision making
Heuristics or mental shortcuts are helpful in dealing with complex issues but are also prone to biases which can lead managers to make errors in strategic decisions.
- Article |
- 01 May, 2010
- The mental constraints involved in solving a problem make heuristics a useful tool in dealing with complex issues, in which we are prone to biases and judgement errors.
- Mental shortcuts and mental accounting, drawing on similar events to solve new problems, and anchoring based on previous knowledge can lead to poor strategic decision making.
- Loss aversion, hindsight bias, and overconfidence can make us naive to a problem and hide structural issues that need to be addressed.
- By becoming aware of such biases leaders can begin the journey to better decision making.
Heuristics are inherent in decision-making
Top executives are entrusted to make difficult, complex judgments which are critical for their organisation’s success. A wrong decision by the CEO can cost a company dearly at best and can put the business in jeopardy at worst. The prevalent economic thinking assumes that people can make rational decisions and choose the best option available to them. However, this thinking has recently come under attack from several researchers in psychology and social sciences. The economic tsunami which swept away countries and companies around the world in 2008 has exposed the weakness in purely rational thinking prevalent in economics.
Herbert Simon, a Nobel laureate, demonstrated that people exhibit bounded rationality while making decisions. The ability to make rational choices is bounded by insufficient information about the problem and relevant criteria, the constraint of time and cost on quality and the amount of data and mental constraints to solve the problem.
As a result, people compromise on the best possible solution and go for what is acceptable. In the words of Simon, people satisfice rather than optimise while making decisions.
Dealing with strategic decisions e.g. entering new markets, selling or acquiring businesses or developing a new product involves an element of uncertainty. Executives have to assign probabilities to future events and put a value on that event while making strategic decisions. But how do people assign probabilities to uncertain events? In many cases, we use rules of thumb or mental shortcuts for solving complex problems or coming to judgments, typically when there is incomplete information as is the case with many strategic decisions. These rules of thumb are referred to as heuristics. “They serve as a mechanism for coping with the complex environment surrounding our decisions.”
We can see the usefulness of heuristics in our daily life. The distance of an object can be estimated from how sharply it is visible to the eyes. The sharper the object, the nearer it is to our eyes. However, the use of this heuristic can lead to errors in the estimation of distance if the visibility is poor. Distances are often overestimated when visibility is poor. Heuristics, though helpful in dealing with complex issues, are far from perfect and are prone to bias. Most of the time, we are oblivious to these heuristics and their effect on decision making. As a result, executives like anyone else commit errors in their decision making. Behavioural economics has developed as an area to deal with such situations where a host of human biases can affect decisions. In this article, we present seven such biases which can affect strategic decisions and the ways to avoid them.
People assess the probability of an event by the ease with which occurrences of the event can be brought to mind. This is called availability heuristic, a helpful mental shortcut for assessing probability because larger classes are recalled better. However, availability is affected by factors other than frequency and probability. We have a tendency to give preference to recent information, vivid images that evoke emotions, and specific acts and behaviours that we personally observe. All these cause biases in decision making.
Let us ask you a question: what is the more likely cause of death in the US
a) Shark or
b) Being hit by airplane parts?
The answer to this question depends on your own exposure to the subject matter. It depends on what is familiar, vivid, concrete, recent, unusual, highlighted by media or readily recalled or imagined.
While making strategic decisions e. g. entry into a new market, executives look for information to assess market attractiveness based on market size, growth rate, ease of entry, level of competition and profitability of existing players among others. Even if the information is available and can be analysed, managers often look for what is immediately available or can be easily recalled.
In our work, we have come across instances where the attractiveness of market entry was evaluated by government sops and tax benefits because information about them was easily available and vividly presented by the media and trade publications.
The biases emerging from availability heuristics can be avoided by asking questions about the availability of information, its source and ‘stripping away’ hype.
An effort to broaden the information base can alter the picture considerably and can even change the attractiveness of the proposal. Executives can also include more people in the decision-making process to bring different perspectives for consideration. The inclusion of more people can increase the likelihood of discovering information which does not conform to the decision maker’s frame of mind.
The unrecognised tendency of decision makers to judge the likelihood of an event’s occurrence based on its similarity to previous events leads to representative bias. Schwenk who has studied the effect of heuristics and biases on strategic decision making gives an example of representativeness bias from the US retail industry. The head of an American retail organisation held a belief that there would be a depression after the second world war. His belief was based on the knowledge that there was a depression at the end of the first world war. So strong was his belief that he did not expand his business in spite of strong competition by a major rival. The result was a permanent loss in market share.
Closer to home, we have seen representative bias in listing on stock exchanges. For example, during the boom years, many real estate companies raised finances through Initial Public Offerings (IPOs) with quite high book-building prices. When initial companies did well in their IPO, other companies followed suit. They assumed that the earlier company which floated the IPO was a representative one and retail investors who would have missed the opportunity of investing earlier, were eager to invest in the subsequent IPOs. This kind of judgment is based on stereotype successes, ignoring many other factors which might have affected the decision of earlier companies to go for an IPO.
Managers need to challenge their assumptions and long-held beliefs to deal with representative bias. It is worth questioning whether a generalisation based on one example or a small sample holds true. Using a devil’s advocate can also be helpful in challenging assumptions which can go unnoticed on one’s own - especially when they are long-held views.
Anchoring and adjustment
Anchoring is a prevalent trap in decision making. It is so common that sometimes it is hard to think that the decision may be biased because of the anchoring trap. Our mind works in such a way that the initial data, estimates, and impressions affect subsequent estimates even after making adjustments. The mind gets anchored on those initial estimates so much that any decision made later would have revolved around what was presented initially.
For example, in an experiment, people were asked to estimate the population of Turkey by asking them two questions:
Is the population of Turkey greater than 35 million?
What is your best estimate of Turkey’s population?
It has been consistently found that the figure 35 million (chosen arbitrarily) in the first question affects the answer to the second question. In fact, when the figure was changed from 35 million to 100 million, the answer to the second question increased by many millions.
Analysts project Sales, EBITDA, and 3-year order pipelines based on a company’s recent results and announcements. Their recommendations will be based on these anchored figures and they go on adjusting and readjusting their initial data as and when they gather further information about the company. This kind of anchoring is done in the case of analyst forecasts, budget processes, P/E (Price Earnings Ratio) adjustments for risk and use of share prices – high/low.
In a negotiation process, anchoring is used as a tool by giving the first set of expectations or estimates. The buyer starts with an extremely low price and the seller starts with an extremely high price and they go on adjusting the price as the situation demands. Later, the discussions and negotiations revolve around the initial data.
To avoid the anchoring trap, it is first important to be aware of this trap when the big decisions are made. Understanding in what forms anchoring can appear and in what decision making situations it can be present helps in building the first guard against it. However, to ensure that the decision-making process is not guided by anchors, executives can take a different starting point and view the issue at hand from multiple perspectives. Involving people with different thinking styles can bring fresh ideas and keep the anchors away from discussions.
Loss aversion is a human tendency to prefer avoiding losses than acquiring gains. According to prospect theory, ‘losses loom larger than gains’; a loss has typically two and a half times the impact of a gain of the same magnitude.
It is very common to see people hate to lose. People keep the purchase price of a stock as a key reference point and do not mentally relate the current price to the market levels. Generally, investors sell their winning stocks too soon and hold on to their loss-making shares too long.
In an experiment with 130 customers, it was found that a price increase of $200 was viewed differently depending on whether it was considered as an increase in loss or a reduction in gains. In the first case, customers were put on a waitlist for 2 months for a new model of a car. The dealer who was selling the car at list price increased the price by $200. 71% of customers felt this was unfair. In the second case, a dealer who was selling the car at a discount of $200 below the list price started selling at the list price after the shortage. While the monetary effect was the same in both cases, only 42% of customers considered this as unfair in the second case.
Loss aversion leads to status quo bias in decision making where people prefer maintaining the status quo to avoid losses. Status quo bias can lead to poor strategic decisions where executives avoid making decisions because of their aversion to loss. For example, executives can be slow in responding to competitors’ price cuts thinking that it will lead to profit erosion. As a result, the aggressive competitor might gain a large market share in the interim. The status quo bias can also lead to delays in the adoption of new technologies which can become a game changer but are not yet proven and tested. A rigorous analysis which looks at the risks of not making a decision can help in dealing with the status quo bias.
Mental accounting is a set of cognitive operations used by individuals and households to organise, evaluate and keep track of financial activities. Imagine two business people who leave the same hotel at the exact same time to catch different flights from the same airport. By coincidence, their flights are scheduled to depart at the exact same time. Both take taxis and get caught in traffic. They both arrive at the airport at the same time, thirty minutes after the scheduled departure time. Both rush to their gates. Mr A finds that his flight has left at the scheduled time. Ms B finds that her flight has left the gate, but just two minutes ago. In fact, it was just heading down the runway when she was at the appointed gate.
Who feels worse?
(a) Mr A, or
(b) Ms B
Richard Thaler, at Graduate Business School, University of Chicago says that three components of mental accounting are important to note. The first refers to how outcomes are perceived, decisions are made and how they are subsequently evaluated. The second involves grouping activities into different categories and monitoring them with an implicit or explicit budget. Finally, it is the frequency e.g. daily, weekly, monthly or yearly at which accounts are evaluated.
Investors keep a separate mental account of each stock and they also keep a separate mental account of the dividends and the capital portion. Normally they try to postpone on a loss-making stock because of such mental accounting and wait for a losing stock to come back to at least its original price so that the loss is not felt. When investors are able to sell the stock at the purchase price, they consider it as a psychological gain. Many people prefer the dividend option in case of mutual funds since it is easy for the mind to make out what gain has been made in a particular fund.
Mental accounting is at play during strategic decision making in a number of cases. New products or new businesses have less stringent controls compared to current businesses in the name of growth opportunities for the company. At the same time, the existing business might be scrutinised under strict criteria. To avoid the mental accounting trap in decisions, managers should set a clear set of criteria for evaluating all expenditures. The criteria should be aligned with the company’s strategy and be measurable.
Hindsight bias is a tendency to see things as more predictable and obvious once they have occurred whereas in fact the event could not have been reasonably predicted before the onset of the event.
It is easy to believe something as obvious in hindsight. Other people’s past decisions may look wrong though they would have taken the reasonable decision based on the facts available at that point in time. It is easier to reconstruct why something worked or did not work after the event has happened.
We could pull all logical strings into our reasoning and draw sound conclusions about the past events. B-Schools have long used the case study method to teach about ‘real’ business issues - from operational to strategic - faced by managers. Since it is easy to reconstruct the past when the event has occurred, there is a possibility of introducing hindsight bias by teaching through cases.
Warren Buffet’s Berkshire Hathaway has posted an extraordinary performance: rising from $18/share in May 1965 to $71,000/share as on 31 December 2000, giving a 26.2% annualised return compared to 11.7% on the S&P 500. But did you know of his abilities in foresight or only in hindsight?
Hindsight bias can have serious implications for making strategic decisions. Managers can assume the future to be more predictable in developing strategies rather that it would be. As a result, they may face challenges executing those strategies or may not achieve projected results when the external environment changes. In this era of high uncertainty in the external environment, there is even greater need to be aware of hindsight bias.
Managers can better deal with this bias by considering multiple future scenarios so that the organisation's response can be thought through if any one of the scenarios materialises. Hindsight bias can also be addressed by building in flexibility in the organisation so that it is easier to change course if the situation changes.
Being confident is considered a great asset in the business world. And it is true that entrepreneurs cannot think of ‘taking the plunge’ until they are confident of their idea. It has however been found that we systematically overestimate our decision-making abilities with what objective circumstances would warrant. If the skill required is greater and the task is more complex, we are more confident in our abilities and judgments.
Related to overconfidence is a bias of over-optimism. We tend to be over-optimistic in predicting what we desire will happen.
When we have more information, we feel more confident (illusion of knowledge). Similarly, if we spend more time on analysing the situation and the longer the run of prior successful outcomes, we feel we have more control over the outcome (illusion of control).
These two biases - overconfidence and over-optimism - can have a major effect on the quality of a strategy or the assumptions made to develop a strategy. The tendency to see the future through the lenses of overconfidence and over-optimism can result in unrealistic forecasts which are not met, investments based on assumptions which have not been tested and estimation of synergies in an acquisition which are never realised.
There are numerous examples of failed market entry by multinational companies in India. These companies have overconfidence in their brand and assume that they can replicate their success in the Indian market but they find it difficult to do that because of differences in market conditions, consumer behaviour, and infrastructure constraints.
To deal with the overconfidence trap, challenge your most pessimistic assumptions and see what happens if the situation gets many times worse than the most pessimistic scenario. Think of how many businesses would have been in a better position if they had challenged their thinking in this way before the global financial crisis of 2008?
It is important to ask ourselves whether we get carried away by any of the above biases while making decisions. Awareness about the likely biases which play in our decision making helps in introspection when things go wrong and can help in making better quality decisions in the future.