Heuristics and Biases in Decision Making Owen Darbishire 10 th July 2008

Heuristics and Biases in Decision MakingOwen Darbishire10th July 2008

Objectives • To understand how people make decisions • To recognise common heuristics and biases in decision making • To reflect upon the consequences of those for organisations • To recognise the limitations of considering individuals devoid of social context

Table Sizes and Shapes

Action and Belief in Decision Analysis Rational Models • logical analysis of decision task and use of deductive methods to derive behaviour or rational actors e.g. expected utility theory Descriptive • empirical, often psychological, seeking general principles to explain observed preferences e.g. identification of heuristics and biases

Concept devised to address growing evidence of non-rationality in decision making; used in two rather different senses: 1. Rationality limited by processing and informational requirements - sets of decisions involve such complexity that rationality affected 2. Rationality systematically impaired by cognitive factors which cause patterned deviations from optimum Bounded Rationality [Simon 1957]

Auction Rules • Only bid if you want to, it’s real money • Bids start at £1 and rise by 20p each bid • The highest bidder pays the amount they bid, and they win the £10 • The second highest bidder also pays the amount they bid, but they don’t win the £10 Small Print: If anyone breaks Rule 2, they will be fined £10.

Commitment “If at first you don’t succeed, try, try again. Then quit. No use being a damn fool about it.” W.C. Fields • As resources (time, money etc.) are invested, the tendency to become committed grows. • Resources are then allocated to justify previous commitments, especially if a justification can be found for initial failure (e.g. economic downturn). • The danger is non-rational escalation

Escalation of Commitment • Examples: • Investments for ‘winner take all’ markets • Pharmaceutical industries, software etc.. • Marketing races, such as airmiles • Arms races and wars • Strikes • Employee Performance Evaluation • Subjective performance appraisal ratings • Promotion decisions • NBA - draft choice and playing time • Loans for commercial investments

Escalation of Commitment Errors in gathering &processing informationImpression management Competitive irrationality Commitment to initial decision Escalation ofcommitment

Penny Auction • The container has a large number of 1p pieces within it. • There will be one round of simultaneous bids only • The winner will be given larger denominations notes and coins to avoid you having to have all those 1p pieces.

Over-Bid Frequency Quantity Bid Estimate = Actual Value

Winning Auction • Rational Bidding Distinguishes (a) expected value of object for sale on prior information available (b) the expected value conditioned on winning the auction • Errors (i) overconfidence in own estimate (ii) ignoring cognition of others (iii) irrational escalation to win auction

Winner’s Curse • The more uncertain the value, the more likely it is overpaid for • Learning is difficult: • outcomes delayed • variability in environment degrades reliability of feedback • the most important decisions are unique • Mergers • Bidding for competitive contracts • 3G Mobile Licence Auctions

3G Mobile Licence Auctions Estimated Price - £1.5-£2.0 billion Actual Price – £22.47 billion (Cost of licence excludes cost of roll out) “Winners” – TIW, Vodafone, One2One, Orange, BT Cellnet “Losers” – WorldCom, Telefonica, NTL (backed by France Telecom) “If properly designed - and my team deserves credit for not screwing up the design - auctions are simply a way of finding the market price… . If chairmen paid too much for their licences, they have nobody to blame but themselves ” – Ken Binmore “A ruthless, poker-playing economist” – Newsweek

Anchoring • People adjust rather than create when making decisions • Adjustment requires an anchor • Example: estimate the value of the following numbers • 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8 = 512 • 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1 = 2250 • Sources of anchor include: • first source of information; stereotype; advertised price; behavioural signals; initial position in negotiation

Number Selection • Three numbers you will be given conform to a simple rule. This rule is concerned with the relation between any three numbers and not with their absolute magnitude (i.e. it is not a rule like all numbers above 50). • Your aim is to discover the rule by thinking of sets of three numbers. On doing this you will be told whether the numbers conform to the rule or not. • Try to discover the rule by citing the minimum sets of numbers. • When you are highly confident of the rule, write it down.

Confirmation Bias & Perception • Selectively perceive what they expect / hope to see • Heuristic of positive test strategy • Mynatt, Doherty & Tweney (1977) found 70% of subjects used confirmation strategy even when instructed to disconfirm • Cognitive Dissonance • people reduce or avoid psychological inconsistencies • self perception theory indicates that people discover their own attitudes & emotions by watching themselves behave in various situation.

NASA engineers asked to examine whether problems with o-rings on space shuttle were related to take-off temperature Challenger Space Shuttle NASA engineers asked to examine whether problems with o-rings on space shuttle were related to take-off temperature STS 51-C Graph of temperature and o-ring performance for flights where problems occurred (drawn before Challenger) 3 61A 2 # Incidents 41D 41B 41C 1 61C STS-2 0 50 55 60 65 70 75 Temp oF

Confidence Confidence Estimation Exercise - 90% accuracy

Question 1 How long, in days, is the gestation (pregnancy) period of an Asian elephant Question 2 How deep, in either feet or meters, is the deepest known point in the ocean ?

Question 3 The figure below provides the dollar share price chart for a particular security over a forty-eight month period. What is your prediction for the dollar share price six months beyond this forty-eight month period?

Question 4The figure below provides the dollar share price chart for a particular security over a forty-eight month period. What is your prediction for the dollar share price six months beyond this forty-eight month period?

Question 5The figure below describes the dollar change in share price for a particular security over a forty-eight month period. What is your prediction for the average change in the share price, per month, for the six months beyond this forty-eight month period?

Confidence • There is only weak relationship between confidence and accuracy: • Fischoff, Slovis & Lichtenstein (1977) found where people put odds of being correct at 100:1 they were accurate 73% of the time • Average confidence levels don’t appear to exceed accuracy by more than 10-20 percent, so usually not catastrophic results • Strategies for overconfidence • consider why you might be wrong • list alternatives • generate opposing reasons (not just reasons)

Overconfidence Source: Plous 1993

Retrievability & Availability Bias Decision makers assess the frequency of a class or the probability of an event by the ease with which instances or occurrences can be brought to mind • Availability of information • Imagination of event • Vivid information given (versus pallid or statistical data)

Our firm is in trouble – we are cutting jobs. HR director presents 2 plans: Program A Save 1 in 3 plants and 2000 jobs Program B 1/3 probability of saving 3 plants & 6000 jobs 2/3 probability of saving nothing

Our firm is in trouble – we are cutting jobs. Operations director presents 2 plans: Program C Will lead to the loss of 2 of the 3 plants and 4000 jobs Program D 2/3 probability of losing all plants and 6000 jobs 1/3 probability of losing nothing

Framing The manner in which issues or questions are phrased has a significant impact on answers and preferences. Gains versus Losses • risks about gains and losses are perceived differently • people are risk averse when gains are at stake • people are risk seeking in face of losses • If people do not adjust their reference point as they lose, they may take risks that they would ordinarily find unacceptable.

Representativeness • Refers to judgements based on stereotypes • “Law of Small Numbers” (Kahneman & Tversky 1971) • e.g “bad” or “good” stocks (Shefrin 2000) • Causes individuals to fail to appreciate the role of sample size in assessing reliability of information, and an ignoring of regression to the mean • Gambler’s Fallacy: reversal of chance is due • e.g. 5 heads in toss of a coin. What next?

Does Leadership Matter? The Attribution of Success Grint 2000

Fundamental Attribution Error The tendency to over-emphasis dispositional or personality explanations, and to place too little emphasis on the situation, environment or chance • Longing for saviour, search for scapegoat • Observers & leaders suffer this heuristic • Power and prestige exacerbates the effect • Good leaders in bad units beware!! • Cultural differences in attribution

How Much Does Leadership Matter? • Direct Leadership • Effect of immediate supervisor on organisational climate (Hogan et al 1994) • Small groups such as NBA (Smith et al 1984); Baseball (Kahn 1993) • Indirect leadership • Autos (Lieberman et al 1990) • CEO hubris and price paid for acquisition (Hayward and Hambrick 1997) • Reality of organisational power and environmental constraints • Overall – effect in larger organisations greatly overstated • Problem exacerbated by search for charismatic CEO (Khurana 2002; Collins 2001, 2005; Maccoby 2002)

Distribution of Gifts • £100 is to be split between two strangers: • X gets to decide the division • Y gets to accept or reject that division • No negotiations occur – the money is divided as X determined or rejected completely

Equity and Fairness • People continually make comparisons with others and this has a significant effect on such issues as pay systems • Fairness is a fundamental principle of societies, even if the precise ‘divisions’ show variation. Two forms of fairness matter: • Distributive Justice • Are rewards distributed ‘fairly’ given differences in skills, experience, effort and performance? • Procedural Justice • Is the method of determining the distribution of rewards ‘fair’ and ‘equitable’?

Categories of Cognitive Bias • Influences on information gathering • Retrievability & availability, confirmation bias • Influences on information processing • Loss aversion, over confidence, framing, anchoring, representativeness • Influences on decision making • Groupthink, herding, social norms, impression management, competitive pressures, endowment effects • Influences on reactions to decision making • illusions of control, escalating commitment, hindsight bias, fundamental attribution error

Examples of how to deal with biases • Reframe questions/issues in neutral terms • Initially form a view independently to avoid anchoring • View problems from different perspectives to uncover your implicit assumptions • Seek information/opinions from various sources to widen frame of reference • Seek out people most likely to challenge your assumptions • Avoid using leading questions when asking for opinions • Apply equal rigour to analysing all sources of evidence Always be alert to possibility of others peoples’ biases and try to identify their implicit assumptions

What is missing? • Focus has been on heuristics and biases • We are missing context: • Personality • Social Interaction • Groups • Culture • Power & Politics • Organisational Structure

Risks with Group Cultures • Group Think …the deterioration of mental efficiency, reality testing, and moral judgement that results from in-group processes (Janis 1982) • Group Polarisation • Abilene Paradox

Pick a Number Choose a number between 1 and 100 The winner is the guess closest to two-thirds of the average entry.

Heuristics and Biases in Decision Making Owen Darbishire 10 th July 2008