Tuesday, July 31, 2012

Cognitive biases and strategic decision-making

Daniel Kahneman's book "Thinking, Fast and Slow" synthesizes a great deal of research over the past several decades about the brain's thinking and decision-making processes. It's a great book, well worth reading. But it's pretty long. This article from McKinsey classics, "Hidden Flaws in Strategy," is nearly 10 years old, but is worth reading for its still-valid insights. (It's free after registration.) The article looks at common cognitive biases in decision making and suggests ways to avoid them.

1. Overconfidence/overoptimism - we tend to look at the bright side, and wildly overestimate our abilities to predict. To counter this tendency, the authors advise testing strategies under a wide range of scenarios, taking the most pessimistic scenario and making it worse, and ensuring that you have the capacity to be flexible as uncertainties resolve.

2. Mental accounting - we all put some spending into categories that saves us from having to look at it too closely. The authors recommend adherence to "a basic rule: that every . . . dollar . . . is worth exactly that, whatever the category. In this way, you will make sure that all investments are judged on consistent criteria . . . "

3. Don't be too wedded to the status quo, but be prepared to stick with it when it's the better choice. How to tell? The authors recommend two approaches: a) Take a radical view of your entire portfolio of programs and consider closing or changing all of them; and then b) Analyze your status quo options the same way you would change options. "Most strategists are good at identifying the risks of new strategies but less good at seeing the risks of failing to change."

4. Anchoring - Our brains tend to stick with, or anchor, to a suggested number, whether it is relevant to whatever we've been asked about or not. Sellers might use the tendency to their advantage during negotiations or advertising. But the tendency can impair decisions. Put comparisons in a larger context: 20-30 years, for example.

5. The sunk-cost fallacy - loss aversion and anchoring often lead us to continue an investment even after it has turned sour. To avoid it, the authors say, look at each incremental investment separately, with a fully analysis. Be ready to end experiments early. And condition further funds on meeting certain targets.

6. Know when to follow the herd - and when to go your own way. Good strategies often break away from a trend, the authors say. Combined with the principle of ending experiments early, it's can be smart to disregard the received wisdom.

7. Know when to get excited. OK, the authors don't quite put it this way, but a wise woman I once worked for did. Sometimes waiting and seeing is the best policy.

8. Make sure your consensus, when you have one, is real. False consensus can be reached when a strong leader thinks she has sought and received objective counsel but for whatever reason (they can include pressure to agree, selective recall, confirmation bias, or a biased evaluation) the consensus is a false one. To minimize the risk, the authors say, make sure your culture values challenges and open criticism. In addition, make sure the strong players have checks and balances so that they can't simply dismiss challenges to their proposals without reviewing them. And, as I said yesterday, make sure you search for as many reasons not to do something as you can come up with for a reason to do it.

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