Entrepreneurs should be aware of these 3 cognitive biases
This article will describe three cognitive biases that could interfere with the success of your business
Cognitive biases are systematic deviations from rationality that affect the decisions and judgments that people make.
One example is the sunk cost fallacy, which is people’s tendency to continue investing resources to salvage an initial investment rather than cutting their losses (also known as throwing good money after bad). The researchers who first identified cognitive biases, Amos Tversky and Daniel Kahneman, theorized that they exist because of humans’ use of heuristics, which are mental shortcuts people use to estimate the probability of uncertain occurrences. Heuristics help people make decisions quickly even without all the information, which is adaptive from an evolutionary biology perspective but also leads to severe, systematic errors in judgment.
As an entrepreneur, being aware of cognitive biases is crucial to running a successful business. Otherwise cognitive biases may be causing entrepreneurs to make suboptimal decisions about their businesses without realizing it. This article will describe three cognitive biases that could interfere with the success of your business.
Confirmation bias is our tendency to seek and latch onto information that supports our beliefs and ignore and explain away information that contradicts our beliefs. Our beliefs are intertwined with our egos, so information that supports those beliefs is ego-enforcing whereas contradictory information is ego-denying and causes uncomfortable cognitive dissonance. In order to resolve the cognitive dissonance, we tend to take the irrational approach of minimizing or rationalizing contradictory information rather than modifying our beliefs. For example, someone who believes that the earth is 6,000 years old who is presented with evidence of dinosaur bones is apt to say that humans and dinosaurs roamed the earth together 6,000 years ago rather than changing his or her belief.
Confirmation bias can potentially be a threat to any aspect of your business when you are faced with a decision about which you already have an opinion about what course of action is best. It can cause you to seek information that supports your belief and be less open to information that contradicts your belief. This can result in making decisions without properly considering the pros and cons of all the options although you may feel like you did in fact consider all information – confirmation bias is sneaky! Confirmation bias can be a particular problem in businesses that are hierarchical because subordinates may hesitate to even raise points that conflict with the opinions of their superiors, and, even if they do, their superiors may explain away and dismiss their points.
Jeff Bezos said being able to change your mind based on new information is a critical trait that is necessary to be “right a lot”. Entrepreneurs who are right more often than average have a high chance at success. He added that people who are wrong a lot are “obsessed with details that only support one point of view” (that is, they are experiencing confirmation bias). The people who are right a lot are able to change their minds about something after learning new information on a dime. Steve Jobs was infamous for doing this. Of course, business owners should not change their minds excessively either, but the point is don’t let your need to be right interfere with changing your mind upon learning new information. Let go of the need to be right. Otherwise your ego will be enmeshed with your ideas, and confirmation bias will creep in and cause you to seek information that makes your idea “right” and ignore contradictory information.
Sunk Cost Fallacy and Loss Aversion
As described above, the sunk cost fallacy is our tendency to throw good money after bad because we don’t want to accept that an initial investment is in fact lost. A good example is gamblers who double down after a loss trying to earn back what they lost instead of cutting their losses. A related cognitive bias is loss aversion – humans want to avoid losses far more than they want to seek gains, so people are more willing to take big risks to avoid a loss than to obtain a gain. Loss aversion is part of what drives the sunk cost fallacy. In the context of business, the sunk cost fallacy and loss aversion are relevant when entrepreneurs make an initial investment in a business, and the business has been unprofitable for an extended period of time, and they face the decision of whether to keep investing or to close the business. These cognitive biases will make business owners prone to keep putting money in, hoping to salvage that initial investment, and to take large risks to avoid realizing that loss (such as incurring debt with unfavorable terms and personally guaranteeing it), when the correct choice may actually be to close the business. The advice to “fail fast” exists to help people avoid the tendency to continue investing resources into a failing venture.
New businesses that make their number one priority reaching profitability (see my bible, Profits First by Michael Michalowicz), which in this case means being cash flow positive*, can avoid falling prey to the sunk cost fallacy because their owners are less likely to face the question of whether to keep investing resources into a cash-guzzling business. Thus, one strategy to avoid the impact of these cognitive biases is to focus on reaching profitability. Another approach is, before opening a business, to decide how much to invest in total (initial investment plus additional liquidity infusions). If, by the time you have invested that amount, the business is not profitable and is not getting closer to profitability, and you cannot see a path to profitability at that time, seriously consider closing. Of course, this analysis is highly dependent on the specifics of a business and its context, and it is hard to speak about in absolutes, but the point of this exercise is to at least have guardrails in place to make business owners take a step back and consider whether to keep putting money in, especially if that money is supplied by debt.
*For purposes of this article, profitability means being cash flow positive. You can be profitable according to your financial statements but still need to be investing more cash every month.
Overconfidence and the Dunning-Kruger Effect
Psychologists have demonstrated that people tend overestimate their abilities and underestimate the abilities of others. Ninety-five percent of drivers believe they are above average drivers and eighty percent of people believe they have above average intelligence. A related cognitive bias is the Dunning-Kruger effect: people who are beginners in a field overestimate their abilities significantly more than experts in that field. The researchers who identified this hypothesized that the reason for this is that experts know what they don’t know while beginners are blithely unaware.
If you are a first time entrepreneur, it is particularly important to be aware of the Dunning-Kruger effect because you are at risk of being too confident that your business will be successful without realizing that you don’t know what you don’t know. Overconfidence can cause entrepreneurs, regardless of experience, to overestimate their chance of success and underestimate their competition. You have probably heard the oft-quoted adage that most small businesses fail, but you probably think that the chance of your business failing is small (frankly, I think that about my business, too, even knowing about cognitive biases – overconfidence is powerful!). At the extreme, these cognitive biases could result in entrepreneurs starting a business that has little chance of success (which can lead to a disaster when coupled with the sunk cost fallacy and loss aversion that cause one to keep investing resources to salvage an initial investment). Less extreme risks are that you overlook shortcomings in your business and that you don’t have a plan for handling competitors because you underestimate the threat they pose.
Steps to Mitigate the Impact of Cognitive Biases
The good news is that there are steps you can take to limit the impact of cognitive biases on your business. The first step is to simply be aware of them and consider whether they might be impacting your decision-making around your business. Another way to decrease the impact of these biases on your business is to involve other people. An experienced mentor can be a lifesaver. They can identify shortcoming in how you run your business and will probably notice the poor decision-making that result from cognitive biases. The more brutally honest, the better. Invite real feedback from your employees, particularly as to the aspects of your business that they are most familiar. You can also seek feedback on your business model from investors or lenders if you are getting outside capital. No matter whether it is a mentor, employee, or investor, though, you must be truly open to receiving their critiques. Pay attention to whether you are getting defensive or are minimizing or rationalizing their points – that is a clue that cognitive biases may be at work. The three cognitive biases mentioned in this article are only a tiny fraction of the nearly 200 that researchers have identified so far – keep an eye out for future articles on this topic!
Emily Stork is a general corporate and finance lawyer at Holland & Hart LLP in Denver. She is admitted to practice in the state of New York and in the state of Colorado.
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