One bad decision begets another
Category : Decision Making
If you haven’t already read Daniel Kahneman’s excellent book ‘Thinking, fast and slow’ you might want to put it to the top of your ‘to read’ list. It fundamentally challenges much of the received wisdom about decision-making. Anyone who needs to make significant business decisions should understand the implications of Kahneman’s work (which earned him a Nobel Prize in economics).
The fundamental point he makes is that most people don’t make most decisions rationally.
Kahneman explains that we all have inbuilt biases, most of which we are unaware of – and when we are aware of them, we often find it difficult to overcome them. This doesn’t make us irrational, it just means we don’t conform very well to the ‘rational agent model’ which underpins classical economics and traditional theories of management decision-making.
Some of our main biases, which mean we don’t evaluate potential gains and losses equitably, are:
• Loss aversion (the fear of losing is greater than the hope of gaining)
• The endowment effect (the maximum price we would pay to acquire something is less than the minimum we would be prepared to sell the same thing for)
• The sunk-cost fallacy (taking into account sunk costs, which should rationally be set aside, leading to ‘throwing good money after bad’)
The title for Kahneman’s book refers to our two natural ways of thinking: ‘System 1’, the automatic, fast and intuitive way; and ‘System 2’, the slow one we use for complex problem solving which also can, with effort, overrule the quick and easy suggestions made by System 1.
A recent article in the Economist (see link 1 below) describes research into gambling which adds to this thinking. Winning gamblers tend to choose safer and safer odds, which often extends a winning streak, whereas those on a losing streak take ever riskier bets, making it more likely their losses will continue.
Furthermore, research published in Neuroscience (see link 2 below) suggests that rats ‘regret’ decisions – implying that our decision-making behaviours have evolved way back, are shared with many other animals, and are deeply embedded in our subconscious (these form part of System 1).
Taking all this together it is clear that there are significant risks that we don’t always make a ‘rational’ business decision (i.e. choose the option with the best potential outcome, given the information to hand). And in a tough business environment, particularly if an earlier decision has not turned out well, the temptation to make a riskier decision is greater.
Just because things are going well doesn’t mean we will naturally make better, more rational, decisions – then there is a tendency to be conservative, potentially missing out on a good opportunity by being too risk-averse.
The implications are clear if you are a decision maker – you need to work at making rational decisions. Use quantitative techniques and apply them appropriately. But most of all, be aware of yours, and others’, biases and try to set them aside.
2. Neuroscience: http://www.nature.com/neuro/journal/vaop/ncurrent/full/nn.3740.html