Avoiding Decision Traps

Cognitive biases and mental shortcuts can lead managers into costly errors of judgment.

Consider the work of Paul J.H. Schoemaker, a professor at the University of Pennsylvania’s Wharton School and chairman and CEO of Decision Strategies International, a West Conshohocken, Pennsylvania-based consultancy. Last year, he sought to find out whether anchoring propped up the rate of bad loans at a fast-growing Southern bank. When evaluating a loan’s performance, a bank officer would begin (naturally enough) by reviewing the loan’s current rating. That rating, surmised Schoemaker, would act as an anchor for the new rating — should I upgrade, or downgrade? Because of the anchor, a downgrade would tend to be an incremental adjustment, which meant that by the time a loan was classified as troubled, it could be too late to take remedial action.

Invited to speak to the bank’s top 100 managers, Schoemaker proposed an experiment. Of the next 200 loans they reviewed, he instructed, make 100 of them “blind” — that is, without reference to the previous rating — then compare the two groups and the adjustments they make. “My prediction,” he says, “is that they will make much bigger adjustments with the group that has no anchors.” Schoemaker and the bank’s CEO planned to meet at the end of May to discuss the experiment’s results.

Broadly speaking, anchoring is present whenever one manager or group reviews another’s proposal, says Hersh Shefrin, professor of finance at Santa Clara University’s Leavey School of Business. “The fact that you start with somebody else’s proposal means there’s an anchor being presented to you,” he says. People may be optimistic or want a project to be accepted, and therefore be inclined to inflate cash-flow projections. The challenge for those who sign off on proposals is to adjust sufficiently for the inflation.

Framing

In this heuristic, the way a situation is presented, or framed, greatly influences the action taken. If a frame is poorly constructed, a manager may unwittingly make a money-losing choice.

For example, Shefrin says, managers can stumble by framing costs in the context of gross margin (a financial accounting number) rather than contribution margin (a cost-accounting number). “If they have to decide whether to accept a special order, given their fixed capacity, the criterion they ought to use to make the decision is contribution margin,” notes Shefrin. That measure might indicate that the special order is worth doing — whereas gross margin could show the opposite.

Another psychological tendency, called aversion to a sure loss, can combine with framing to produce the “sunk-cost fallacy.” Studies have shown that people are generally reluctant to accept a sure loss, and therefore are willing to make unsound bets in the hopes of breaking even, says Shefrin. If managers dismiss the textbook advice to forget sunk costs, and instead frame those costs as if they were recoverable, then aversion to a sure loss will tempt them to continue funding a failing project. The companies that have thus thrown good money after bad are surely legion.

Optimism and Overconfidence

As a rule, leaders are optimistic and confident, but behaviorists say that both qualities can be carried to excess. Overconfidence, for example, may lead a CEO to ignore red flags and make a value-destroying merger or acquisition (see “Watch How You Think“).

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