The Danger of Cognitive Biases

Why do some decisions seem so right when they are really so wrong? Because humans evolved with certain cognitive biases that helped us survive, but don't always lead to the best decisions in today's world.

Most work to date in behavioral finance has focused on asset pricing and the behavior of investors. But increasingly, attention is being paid to decision-making in the corporate realm. Because of their training and experience, managers might be presumed to be less likely to use mental shortcuts, and less vulnerable to cognitive biases. True or not, consultants in decision analysis have made a good living by showing managers how they fall into decision traps, and professors have delighted in showing their executive MBA students just how flawed their judgment can be.

Over time, the behaviorists have compiled a long list of biases and heuristics. No one can say with certainty which of these inflict the most harm, but financial managers would do well to watch out for five: anchoring and adjustment, framing, optimism, overconfidence, and self-serving bias.

Sunk costs are one of my favorite examples. You should ignore them when making decisions because they are irrelevant, but we usually can't. If a forecast shows a product won't make any money going forward, there will still be a group that says "wait, we've invested $2 million in this, we can't back out now." Good managers will say yes you can. You have to.

The best way to avoid these decision traps is to be aware of them. I think ten years from now, managerial neuroscience will be a class every B-school student must take.