Decision Making and Corporate Culture

By: Joseph A. Iraci

Risk managers need to be aware of the potential effect cognitive biases and emotions could have on decision making.  As noted by the Federal Reserve Bank of St. Louis in a 2016  article, “For Better or Worse, Your Decisions Matter,” by Barb Flowers, senior economist education manager, “Bad financial decisions by individuals usually ripple throughout society – as do good ones.”  The same way decisions made by individuals ripple throughout society, the sum total of decisions made by individuals within firms ripple throughout the firm and impact corporate culture.  

Cognitive bias refers to the reliance on limited information or preconceived notions when making decisions.  It often causes people to make illogical decisions based on faulty or insufficient information, or possibly previously held beliefs.  Daniel Kahneman detailed System 1 and System 2 thought processes in his book Thinking, Fast and Slow.   System 1 is fast, automatic, intuitive, and largely unconscious, whereas System 2 is slow, deliberate, and analytical.  Pulling your hand out of fire is System 1, but sitting down and analyzing the exposure of a complex trade is System 2.  Both Systems come into play when making decisions. 

Cognitive biases could exist in both System 1 and System 2.  In System 1 our intuition could be at fault, whereas System 2 could have faulty analysis.  Prior to writing Thinking, Fast and Slow, Kahneman won the Nobel Prize for economics in 2002 based on his research done with Amos Tverersky in the 1970s where they debunked the theory that human beings act rationally.  It is the existence of cognitive bias that causes humans to act irrationally.   

Emotion, as a comparison, refers to our frame of mind and is often described as our mood.  For example, fear is a common emotion that may be present when making a decision but it is also an emotion that could lead to an illogical decision because of the level of uncertainty that fear introduces.  How often have you been at a presentation where facts and reason were logically laid out but the decision was different from what was expected?  Risk managers need to be aware of the emotional state of the decision-maker because emotions have the potential when left unchecked to lead to illogical decisions and unintended consequences.  In a white paper titled “Emotions and Decision Making,” by Jennifer S. Lerner, Ye Li, Piercarlo Valdesolo, and Karim Kassam, they note that emotions drive decision-making, and they also note that the field of affective science is relatively new but is making progress on developing theories of decision making. 

Cognitive biases and emotions are neither good nor bad, they simply exist—and risk managers need to be aware of both to mitigate potential negative impacts on decision-making.

Cognitive Biases Impacting Decision-Making

Individual behavior, emotions, personality traits, and life experiences influence our decision-making, and it is more complicated than simply analyzing numbers.  Risk managers use a combination of quantitative and qualitative analyses when making decisions but all decisions ultimately are a judgment call.  There are hundreds of biases. The following are the ones risk managers need to be particularly aware of.  Biases do not exist in isolation; rather there is interaction among different biases.

  • Confirmation Bias – Confirmation bias refers to the behavior where people seek information that confirms a pre-existing belief and ignore more objective information.
  • Anchoring – Anchoring is a bias where a person may jump to a conclusion based on the first piece of information he/she receives or possibly hold onto a belief and jump to a conclusion.
  • Overconfidence – Overconfidence occurs when people have too much faith in their own analysis or ability, possibly leading to higher risk asset purchases or possibly concentrated positions.
  • Planning Fallacy – Planning Fallacy occurs when a person underestimates the time needed to complete a task or overrates the ability to shape the future.
  • Choice Paralysis – Choice Paralysis occurs when a person has too many choices leading to decision paralysis from too much information.
  • Loss Aversion – Loss aversion refers to the tendency for people to sell those assets that have a gain, while retaining assets that have a loss.  Research has shown that people simply feel the pain of a loss more than the joy of a gain.
  • Representativeness – Representativeness occurs when we think recent events will continue into the future.
  • Herding – Herding refers to simply following the crowd.

Emotions Impacting Decision Making

Emotions have the potential to influence decision makers, leading to either a positive or negative result.  As we all know from our own interaction with people, it takes all types of them to make the world.  Think of past risk events and the motivations people had that led to behavior destructive to themselves, the firms they worked for, and the industry as a whole.  What motivated otherwise intelligent people to act in a way that was so harmful to so many stakeholders?  The following are common emotions that are part of our makeup and have the potential to impact decisions:

  • Happiness
  • Pride
  • Confidence
  • Concern
  • Jealousy
  • Resentment
  • Insecurity
  • Entitlement
  • Fear
  • Anger
  • Sadness

In an article in Forbes magazine titled “How The Most Common Emotions Affect Business Decision Making And What To Do About Them,” Erik Larson pointed out that recent research points out that emotional intelligence is a strong predictor of success at work. He also wrote that “When it comes to decision making, a little emotion is good, even if the emotions seem unpleasant or unproductive.  Feeling a little fear, sadness, or irritation can help spark motivation or broaden the search for alternatives.”  He went on to say that problems could arise when there is too much emotion.

Logic and reason are important but risk managers need to understand the emotional drivers that impact a person’s frame of mind when making decisions.

Mitigating Cognitive Biases and Emotions

To mitigate against a negative influence on decision making from cognitive biases and emotions it is important to be aware that both exist, and to have a thoughtful process that reduces the influence of biases.  Several steps can be taken to mitigate both when making decisions.

  • Self-Awareness – Know yourself and your frame of mind when making critical decisions, and know the frame of mind of decision makers in your organizations.
  • Bias Awareness – Biases exist, but by being aware of them we can become better critical thinkers and decision makers.  By being aware we can mitigate against our own blind spots.
  • Situational Awareness – Situational awareness refers to a person’s ability to identify, process, and understand the critical elements of information needed to know what is happening around you.  See things as they are and not as you wish them to be.
  • Objective – Objective refers to knowing what you are trying to accomplish. This objective guides much downstream decision making during the execution phase.
  • Constructive Conflict – Constructive conflict requires people to focus on the end result and to have an open discussion for the benefit of the overall team.
  • Different Information Sources – Look for information from a wide range of sources to consider multiple perspectives.
  • Devil’s Advocate – Seek out others who have different opinions in order to challenge perceptions and conclusions.
  • Brainstorming – Have an open and freewheeling discussion to generate ideas and challenge assumptions.

 Kahneman recommends asking three questions to minimize cognitive bias in decision making.

  1. Is there any reason to suspect the people making the recommendation of biases based on self-interest, overconfidence, or attachment to past experiences?  Realistically speaking, it is almost impossible for people to not have these three influences in their decisions.
  2. Have the people making the recommendations fallen in love with it?  Again, this is almost inevitable because, in most cases, people wouldn’t make the recommendation unless they loved it.
  3. Was there groupthink or were there dissenting opinions within the decision-making team?  This question can be mitigated before the decision-making process begins by collecting a team of people who will proactively offer opposing viewpoints and challenge the conventional wisdom of the group.

Concluding Thoughts

Cognitive biases and emotions have the potential to impact decision making and risk managers need to be aware of the existence of both to mitigate negative effects on decisions.  Biases and emotions are neither good nor bad, they simply exist and risk managers should deploy a thoughtful process that raises awareness of their existence, and deploy a holistic process that ensures we know what the decision objective is and to have a 360-degree view of information needed to assess and make the best possible decision.

Joseph Iraci is managing director of financial risk management at TD Ameritrade. He can be reached at Joseph.Iraci@tdameritrade.com