Bad decision making: 5 major mistakes to avoid

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You may be playing a high-stakes game and risking the future of your practice without even knowing it. DFK partner and forensic accountant Terry Slattery reveals how to recognise the symptoms of bad decision making.

Businesspeople are making decisions literally every minute of every day, yet rarely do they stop to consider both the processes they use to make decisions and more importantly whether those processes may be sub-optimal.

 If asked, most businesspeople would suggest their decisions result from an orderly process of collating and analysing information, applying methodologies, and forming judgements based on their skills and experience. They are often quite surprised when it is suggested that many of their decisions are largely preordained. That is, the decision can be predicted before the information and data on which it is based even emerges. That this is the case is a consequence of the many heuristics we use in making decisions and the biases we have which impact on those decisions.

This article looks generally at heuristics and several more common biases which have particular relevance to business decision makers and poses the question: Would a process of challenging our decision making approach contribute to a reduction of business and investment risk associated with those decisions?

The sheer volume of information which continually surrounds and bombards us means that in the absence of techniques for interpreting and prioritizing this information we would very quickly be overwhelmed. Cognitive psychologists call these techniques heuristics which are simple and effective methods which enable us to make decisions when confronted with voluminous, incomplete or ambiguous data. Common examples are the use of rules of thumb, educated guesses and common sense.

In many situations heuristics enable decisions to be made which are efficient and ultimately value accretive to the business. Some heuristics can and do however lead to cognitive biases which can make our decision making sub-optimal, increase our business and investment risk and possibly be value destroying. The balance of this article looks at several cognitive biases which have particular relevance to the management of risk in business and investment.

Representativeness

This relates to our tendency to compare situations, draw analogies and see similarities when in fact there are not any.

In investment markets we see this in companies being upgraded or downgraded on the basis of broad industry views and their competitor’s performance when in fact they bear no resemblance.

Businesspeople are therefore at risk of ignoring good investment opportunities due to incorrect categorising and taking on increased risk as a consequence of assuming a target investment will exhibit the characteristics of the industry and/or its competitors.

Availability

This relates to the situation where we tend to make decisions based on the information in our memory which is most easily recalled. The downside of this decision making heuristic is that important data relevant to our decision process may be ignored because we are unaware of it.

In business we see examples of this in purchasing decisions being made which favour the supplier who has most repetitively promoted their product to us and in employee appraisal processes where rewards or sanctions are based on the most recent performance.

Anchoring and adjusting

This is the situation where a fixed position is adopted early in the process and adjustments are subsequently made to that position in coming to a final decision.

The obvious problem is that if the initial decision was wrong minor adjustment to that position will still not yield an optimal result. Research into this heuristic shows that decision makers are wedded to their initial anchor and decision making then suffers from inadequate adjustment

Gambler’s fallacy

The gamblers fallacy is the often mistaken belief that if something has not occurred recently it is more likely to occur soon

In business this is seen in managers taking increasingly risky decisions in the incorrect belief that the risk is actually reducing.

Confirmation bias

This relates to the tendency to seek out data and information which supports decisions we have made and to ignore evidence that contradicts the decision we have made.

It is commonly seen in investment decisions where investors seek out information which supports the investment decision they have made and in business managers.

Improved managerial decisions can be achieved by a conscious and critical evaluation of the actual processes we adopt in making decisions. I often advise clients to engage a colleague as a devil’s advocate on the big decisions and to adopt a six monthly review procedure whereby their decisions are critiqued against a framework of heuristics and biases to determine how optimal they have been.

By and large these decision making processes are occurring at a subconscious level and therefore improvements to our decision making and  consequent minimisation of business and investment risk will only come from the conscious application of processes of review and critique.

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