Know and Avoid Common Decision-Making Mistakes

To err is human, but don’t give up! You can learn to make better decisions. You have the intellect necessary to gather and objectively assess the relevant facts. Just slow down, conduct a level-headed analysis and get familiar with psychological biases that tend to derail sound decision-making for humans (so you can avoid them). Here are the common ones:

Recency Bias: tendency to be overly influenced by recent events.

Our memory of recent events is more salient than those of more distant experiences. This seemingly innocuous memory trait can seriously warp our ability to see the world objectively. And because our actions are influenced by our experiences and beliefs, overemphasis on recent events leads to skewed beliefs and inappropriate assessments.

During the bull market of 2003-2008, many investors lost sight of the long-term history of the stock market. They invested as if the future would mirror the more recent past (i.e., steady gains). This occurred in the real estate market, too. But an objective review of the facts would have led one to conclude that the stock market goes up AND down, sometimes way down, and the real estate industry has long been marked by boom-and-bust cycles.

Loss Aversion Bias: tendency to place a higher value on risk avoidance than gain.

Investment involves risk, so persons with a high degree of risk aversion tend to make poorer investment decisions. For example, an overwhelming amount of data supports that the stock market is the best option for at least a portion of one’s long-term investment dollars, but many avoid the market for fear of loss. They choose to invest in more “safe” investments, such as U.S. government bonds, though statistics show that the choice is almost guaranteed to result in substantially lower long-term returns.

Loss aversion plays out with investors in another interesting way — unwillingness to accept loss. So investors deal with a losing investment by rationalizing that it’s not a loss unless and until it is realized, meaning that until they sell out of the position at a loss, they hold onto it. They watch it go all the way to zero instead of doing the rational thing — cutting their losses early and getting their money redeployed into more promising and higher-yielding investments.

Finally, car rental companies prey on this by getting us to buy additional “damage waiver” insurance, and phone companies try to get us to accept flat-fee service to avoid the risk of getting a surprise bill.

Overconfidence Bias: tendency to overestimate one’s own abilities.

Studies show that people tend to overestimate their intellect and abilities. For example, in a spelling task, students scored an 80% on average when they were “100% certain” that they scored 100%.1 Similar to this is optimism bias — the tendency for people to be overoptimistic about the outcome of current efforts or planned actions. This includes overestimating the likelihood of positive outcomes and underestimating the likelihood of negative outcomes, such as graduate school students overestimating the number of job offers they’ll get and starting salary.

It seems that we develop beliefs and then look for supporting evidence. So experts suggest we try looking for evidence that refutes a conclusion or theory that we’ve concocted. Ask others to “poke holes ” or provide refuting information.

Commitment Bias: tendency to support or justify a past decision in the face of contrary evidence.

Irrational loyalty to an old strategy that was previously successful (staying the course) is not in our best interest. Some catastrophic airplane crashes have been the result of commitment bias. Pilots develop a myopic focus on their commitment to on-time arrivals and departures, and ignore clear and obvious danger signs.

Businesses fall prey to commitment bias, too. Experts suggest we step back from the project or task at hand and ask, “If I were just arriving on the scene and reviewed the facts, is this solution the rational one?”

Anchoring Bias: tendency to rely too heavily on one trait or piece of information when making decisions.

When I was a senior in high school, the college I was slated to attend had a very active fraternity/sorority system. I didn’t know which would be best for me, but then I overheard a beautiful older woman say, “Sigma Alpha Epsilon is the best.” That’s all that mattered to me. I ignored every other piece of information and signed SAE. Clearly, my decision was irrationally anchored to a very small piece of information.

Another example is overreliance on the beginning price (i.e., asking price) in negotiating purchase of goods or services. “Hey, this MUST be a good deal, it’s 30% off the asking price.” The subject buyer has anchored his/her assessment of “fair price” or “value” on a single piece of largely irrelevant information — the asking price.

Finally, anchoring bias plays out in everyday life in the tendency of some people to let a single, terrible event dominate their psyche and decision making, such as when an individual avoids investing in the stock market because of a bad prior investment.

Value Attribution: tendency to place value on a person or thing based on a very limited piece of data.

First impressions work this way. When we know very little about a person or thing, we — consciously or subconsciously — imbue him, her or it with the qualities we perceive in the things in close proximity, such as the clothes or surroundings. This is why consumer product manufacturers try so hard to get their products seen with famous people. It’s why packaging matters and Mercedes dealerships are spotless and marble-clad.

But if we want to make better decisions, we must keep in mind that context clouds our ability to see real attributes. We may turn down a pitch or idea presented by the “wrong” person, or blindly follow the advice of someone we highly regard. Similarly, our expectations of “context” influence our assessments. Value attribution bias hinders our ability to objectively assess value. Studies show that the price we pay for a ticket affects our enjoyment of the performance. So make a conscious effort to see things for what they really are and not just how they appear to be. Differentiate between “packaging” and real attributes. Initial impressions can be wrong, of course.

No cure-alls protect you from these biases, but here are some suggestions. First, when you face a financial or business decision and the stress level is high, step back. Take a break, remove yourself from the stress and revisit the decision after you cool down.

Second, if it’s a transaction or business deal you’re already in, ask yourself, “If I were just appearing on the scene, would I get in today at the current terms or would I decline?”

Third, run the facts by a person you trust. Don’t argue with his or her answers, just give him/her the facts as best you can, and gain his/her thoughts and perspectives.

Fourth, once you have developed your interpretation or viewpoint, test it. Look for refuting evidence.

Fifth, remember Warren Buffett’s #1 Rule of Investing — Margin of Error. Our ability to assess and predict is imperfect, so leave a lot of room for error.

Finally, be willing to cut your losses. Get out with what you can and move on to more promising endeavors.

_{1 Adams, P. A. & Adams, J. K . (1960). Confidence in the recognition and reproduction of words difficult to spell. American Journal of Psychology, 73 pp. 544-552.}