Cognitive Bias is a broad term for all distortions in the human mind that are hard to avoid and that lead to a perception, judgment, or reliability that deviates systematically, involuntarily, and rather distinct from the “reality”. Some of the most important cognitive biases for managers are:
• Hindsight Bias. The inclination to see past events as being predictable.
• Fundamental attribution error. The tendency for people to over-emphasize personality-based explanations for behaviors observed in others while under-emphasizing the role and power of situational influences on the same behavior. See: Attribution Theory.
•Rationalization. The process of constructing a logical justification for a decision that was originally arrived at through a non-rational decision process. Can be conscious, but is mostly subconscious.
• Bandwagon Effect. The tendency to do (or believe) things because many other people do (or believe) the same. Compare: Abilene Paradox
•Confirmation Bias. The tendency to search for or interpret information in a way that confirms one’s preconceptions. Also called Confirming-Evidence Trap.
• Status-Quo Bias. The tendency for people to like things to stay relatively the same. The preference towards alternatives that maintain or perpetuate the current situation even when better alternatives exist.
• Self-serving Bias. The tendency to claim more responsibility for successes than failures. It may also manifest itself as a tendency for people to evaluate ambiguous information in a way beneficial to their interests.
• Illusion of Control. The tendency for human beings to believe they can control or at least influence outcomes which they clearly cannot.
• Overconfidence Bias. Overestimating the accuracy of our estimates or forecasts.
• Prudence Trap. When faced with high-stakes decisions, we tend to adjust our estimates or forecast to be “on the safe side”.
• Recallability Trap. Giving undue weight to recent, dramatic events.
• Sunk Cost Bias. To make choices in a way that justifies past choices, even when the past choices no longer seem valid.
• Loss Aversion. The tendency for people to strongly prefer avoiding losses than acquiring gains.
• Anchoring. When considering a decision, the mind gives disproportionate weight to the first information it receives.
• Survivorship Bias. The frequent mistake to forget to include companies that no longer exist in research reports studying various forms of corporate performance.
Managers are well advised to constantly consider the probability that cognitive biases play an unexpected role in their management decisions.
In their book Decision Traps, Russo and Shoemaker reveal the ten most common mistakes in decision-making, many of which are related to cognitive bias:
1. Plunging In: Beginning to gather information and reach conclusions too early.
2. Frame Blindness: Creating a mental framework for your decision.
3. Lack of Frame Control: Failing to define the problem in more than one way.
4. Overconfidence in Your Judgment: Failing to gather key factual information.
5. Shortsighted Shortcuts: Relying inappropriately on “rules of thumb”.
6. Shooting from the Hip: Failing to follow a systematic procedure when making the final decision.
7. Group Failure: Failing to manage the group decision-making process.
8. Fooling Yourself About Feedback: Failing to interpret the evidence from past outcomes correctly.
9. Not Keeping Track: Failing to keep systematic records to track the results of your decisions.
10. Failure to Audit Your Decision Process: Failing to create an organized approach to understand your own decision-making.
A major consequence of cognitive biases for economics, financial practitioners and markets is the Efficient Market Hypothesis does not hold.