Can we be counted on to make sound decisions under uncertainty? Are our judgments always rational? Do we invariably make choices in our best interests, based on a full understanding of trade-offs and probabilities? Are we truly, in short, the homo economicus assumed by many economic models?
Or are we instead a more-flawed species — a creature of bounded rationality, driven by emotions and desires? Is our understanding of probabilities incomplete? Are we susceptible to cognitive biases, and do we confront uncertainty with misleading rules of thumb? Do our decisions, in short, sometimes run counter to our interests?
To those who study behavioral finance, the answers to the sets of questions above are no and yes, respectively. Over the past 30 years, beginning with the seminal work of Daniel Kahneman and Amos Tversky, the behaviorists have demonstrated that people routinely employ heuristics — rules of thumb, or mental shortcuts — to simplify and, worse, oversimplify decisions under uncertainty. Moreover, they have shown time and again that our choices are frequently skewed by an array of cognitive biases.
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.
Anchoring and Adjustment
Kahneman and Tversky contended that people frequently form estimates by starting with a given, easily available reference value — which could be arbitrary — and adjusting from that value. An estimate, therefore, would be “anchored” to that value. (Think of auto salespeople starting negotiations at the manufacturer’s suggested retail price.)
To demonstrate this heuristic, Dan Ariely, professor of management science at MIT Sloan School of Management, conducted a mock auction with his MBA students. He asked students to write down the last two digits of their Social Security numbers, and then submit bids on such items as bottles of wine and chocolate. The half of the group with higher two-digit numbers bid “between 60 percent and 120 percent more” on the items, says Ariely.
“People don’t know how much something is worth to them,” he comments. An anchor helps them decide. Once a value is set, people are good at setting relative values, Ariely explains. But “it’s very hard to figure out what the fundamental value of something is,” he adds, whether it’s an accounting system, a company’s stock, or a CEO.