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The Hidden Traps in Decision Making

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Ankit Saxena
Ankit Saxena

Before deciding on a course of action, prudent managers evaluate the situation confronting them. Unfortunately, some managers are cautious to a fault – taking costly steps to defend against unlikely outcomes. Others are overconfident – underestimating the range of potential outcomes. And still, others are highly impressionable – allowing memorable events in the past to dictate their view of what might be possible now. These are just three of the well-documented psychological traps that afflict most managers at some point, assert authors John S. Hammond, Ralph L. Keeney, and Howard Raiffa in their 1998 article. Still, more pitfalls distort reasoning ability or cater to our own biases. Examples of the latter include the tendencies to stick with the status quo, to look for evidence confirming one’s preferences, and to throw good money after bad because it’s hard to admit making a mistake. Luckily, techniques exist to overcome each one of these problems. For instance, since the way a problem is posed can influence how you think about it, try to reframe the question in various ways and ask yourself how your thinking might change for each version. Even if we can’t eradicate the distortions ingrained in the way our minds work, we can build tests like this into our decision-making processes to improve the quality of the choices we make.

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AUTHOR: ANKIT SAXENA The Hidden Traps in Decision Making
In making decisions, you may be at the mercy of your mind’s strange workings. Here’s how to catch thinking traps before they become judgement disaster. By John S. Hammond, Ralph L. Keeney, and Howard Raffia
Introduction Before deciding on a course of action, prudent managers evaluate the situation confronting them. Unfortunately, some managers are cautious to a fault – taking costly steps to defend against unlikely outcomes. Others are overconfident – underestimating the range of potential outcomes. And still others are highly impressionable – allowing memorable events in the past to dictate their view of what might be possible now. 3
Introduction These are just three of the well-documented psychological traps that afflict most managers at some point, assert authors John S. Hammond, Ralph L. Keeney, and Howard Raiffa in their 1998 article. Still, more pitfalls distort reasoning ability or cater to our own biases. Examples of the latter include the tendencies to stick with the status quo, to look for evidence confirming one’s preferences, and to throw good money after bad because it’s hard to admit making a mistake. 4
Introduction Luckily, techniques exist to overcome each one of these problems. For instance, since the way a problem is posed can influence how you think about it, try to reframe the question in various ways and ask yourself how your thinking might change for each version. Even if we can’t eradicate the distortions ingrained in the way our minds work, we can build tests like this into our decision-making processes to improve the quality of the choices we make. 5
Decision Traps ANCHORING STATUS-QUO SUNK-COST CONFIRMATION FRAMING ESTIMATION Page 7 Page 8 Page 9 Page 10 Page 12 Page 11 6 GROUP THINK VAGUE VERBIAGE OVERCONFIDENCE BASE-RATE Page 13 Page 14 Page 16 Page 17
The Anchoring Trap When considering a decision, the mind gives disproportionate weight to the first information it receives. Initial impressions, estimates, or data anchor subsequent thoughts and judgements. HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP Anchors take many guises. They can be as simple and seemingly innocuous as a comment offered by a colleague or a statistic appearing in the morning newspaper. They can be as insidious as a stereotype about a person’s skin color, accent, or dress. In business, one of the most common types of anchors is a past event or trend. Use alternative starting points Think about the problem on your own Seek information from other sources Be careful of setting anchors yourself 11 99 $30 $80 How much will you bid for this wine? Think of a random number 7
The Status-Quo Trap We naturally look for reasons to do nothing to protect our ego from damage. Breaking the status quo means taking action, which means taking responsibility, thus, opening ourselves to criticism and regret. People sometimes, for example, inherit shares of stock that they would never have bought themselves. Although it would be a straightforward, inexpensive proposition to sell those shares and put the money into a different investment, a surprising number of people don’t sell. They find the status quo comfortable, and they avoid taking action that would upset it. “Maybe I’ll rethink it later,” they say. But “later” is usually never. Never think of your status quo as your only option Would you choose the status quo, if it wasn’t the status quo? Appeal of the status quo will change with time, so keep evaluating Avoid exaggerating the effort to make a change OUTCOME VALUE GainsLosses 1 unit 1 unit 1 unit 1.31 units People give a higher weight to what they already have making them attached to their current situation and goods. Kahneman and Tversky’s prospect theory (1992) showed that people felt losses more than they felt equivalent gains and this loss aversion prompts them to stay with the status quo. 8 HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
The Sunk-Cost Trap We often make choices that justify past choices, even when past choices no longer seem valid. Frequently, it’s because people are unwilling, consciously or not, to admit to a mistake. Acknowledging a poor decision in one’s personal life may be purely a private matter, involving only one’s self-esteem, but in business, a bad decision is often a very public matter, inviting critical comments from colleagues or bosses. If you fire a poor performer whom you hired, you’re making a public admission of poor judgment. It seems psychologically safer to let him or her stay on, even though that choice only compounds the error. Seek other perspectives Examine why an old mistake distresses you Don’t cultivate a failure-fearing culture Be on the lookout for sunk cost 9 HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
The Confirmation Trap This bias leads us to seek information that supports our existing instinct or point of view. There are two fundamental psychological forces at work here. The first is our tendency to subconsciously decide what we want to do before we figure out why we want to do it. The second is our inclination to be more engaged by things we like than by things we dislike – a tendency well documented even in babies. Naturally, then, we are drawn to information that supports our subconscious leanings. Examine all the available evidence Assign a devil’s advocate Avoid leading questions when seeking advice Be honest with yourself about your motives A Q 4 7 A) A, 4 B) A, 7 C) Q, 4 D) Q, 7 If a card has a vowel on one side, then it must have an even number on the other side. Most people choose A and 4 because these are the cards capable of confirming the statement, but confirming evidence doesn’t prove anything – the 4 card has no ability to invalidate the hypothesis. Flipping the 7 card, however, could provide valuable disconfirming evidence – a vowel on the other side means not all cards with vowels have an even number on the other side. 10 HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
The Framing Trap Framing bias occurs when people make a decision based on the way it’s presented, as opposed to just on the facts themselves. The same facts presented in another way can lead to different judgments or decisions. A frame can establish the status quo, introduce an anchor, highlight a sunk cost, or lead you to confirming evidence. Framing can be particularly important when assessing risk tolerance; advisors and clients alike need to make sure to develop a shared understanding of what constitutes risk and should decide how much risk is tolerable for a given client. Don’t automatically accept the initial frame Try positioning problems in a neutral, redundant way Challenge people’s questions with other frames Think hard throughout your decision making process OPTION 1: In Q3, our Earnings per Share (EPS) were $1.25, compared to expectations of $1.27 OPTION 2: In Q3, our Earnings per Share (EPS) were $1.25, compared to Q2, where they were $1.21 Clearly, option 2 does a better job of framing the earnings report. The way it is presented as an improvement over the previous quarter puts a more positive spin on the EPS number. 11 HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
Traps in Estimating and Forecasting Making estimates about time, distance, weight and volume are familiar, and we can get good at those estimations because we can get quick feedback. However, making forecasts with uncertain events is difficult. There are three traps within forecasting: Manage overconfidence by considering extremes Examine your assumptions and get more statistics to reduce recallability Manage prudence with honesty by telling people if estimates haven’t been adjusted Think hard throughout your decision making process Overconfidence We are often overconfident about our ability to forecast. Prudence Trap We err on the side of caution when faced with high-stakes decisions. Recallability Trap Our forecasts are often influenced by our own experiences. 12 HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
13 Group Think Groupthink is a term developed by social psychologist Irving Janis in 1972 to describe suboptimal decisions made by a group due to group social pressures. HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP It is a phenomenon in which the ways of approaching problems or matters are dealt by the consensus of a group rather than by individuals acting independently. Essentially, groupthink occurs when a group makes faulty or ineffective decisions just for the sake of reaching an agreement. The following situations increase the likelihood of groupthink: Vague or abstract words can create confusing meanings in your receiver's mind. They state a general idea but leave the precise meaning to the receiver's interpretation. The following examples show vague or abstract words and ways to make them specific and precise: Vague Precise Many 1,000 or 500 to 1,000 Early 5 a.m. Hot 100 degrees Fahrenheit Most 89.9 percent Others Business administration students Poor student has a 1.6 grade point average (4.0 = A) Very rich A millionaire Soon 7 p.m., Tuesday Furniture An oak desk Group identity When there is strong group identity. Leader influence When a charismatic leader commands the group. Lack of knowledge When people lack personal knowledge of something or feel that other members of the group are more qualified. Cognitive load Where the group is placed under extreme stress or where moral dilemmas exist.
14 The Vague Verbiage Trap HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP Though vagueness often occurs unintentionally, it may also be employed as a deliberate rhetorical strategy to avoid dealing with an issue or responding directly to a question. Macagno and Walton note that vagueness "can also be introduced for the purpose of allowing the speaker to redefine the concept he wishes to use" (Emotive Language in Argumentation, 2014). The following examples show vague or abstract words and ways to make them specific and precise: Vague Precise Many 1,000 or 500 to 1,000 Early 5 a.m. Hot 100 degrees Fahrenheit Most 89.9 percent Others Business administration students Poor student has a 1.6 grade point average (4.0 = A) Very rich A millionaire Soon 7 p.m., Tuesday Furniture An oak desk Vague or abstract words can create confusing meanings in your receiver's mind. They state a general idea but leave the precise meaning to the receiver's interpretation.
15 The Vague Verbiage Trap A corporation’s earnings report needs to be interpreted and digested by both analysts and the market. The conference call accompanying the reports release, predominantly conducted by the CEO and CFO, conveys valuable information that facilitates this process. Word choice by managers affects information processing. In particular the use of uncertain words, such as “probably” and “maybe”, induces investors to respond less to earnings surprises. That is especially true for managers answers to analyst questions. We have established that earnings communicated by vague managers delay the responses of analysts and increase their uncertainty; they also cloud the picture for the majority of investors. These are major consequences but they do not explain why firms might hire vague managers. Could vague talk bring any benefits? The answer is “yes” in a second-best world where managers’ statements that prove to be excessive after the fact get punished. Arguably, this issue would be more pronounced for positive statements, if things later take a turn for the worse. This is especially relevant given the general tendency of analysts to issue overly optimistic forecasts (Hong and Kubik, 2003). Hence, if vague style indeed helps tone down positive expectations, we would expect to see fewer (or less) negative earnings surprises for vague managers. 1. Do managers tilt to vagueness when they have reason to do so, for example to cushion disappointing earnings when her options are coming due? 2. Our method for identifying style can be employed to study other speech characteristics. For instance, do managers differ in their propensity to use positive/negative, quantitative/qualitative, or other types of statements, and what are the capital market effects, if any, of such style differences that are identified? EARNINGS REPORT EXAMPLE Vague or abstract words can create confusing meanings in your receiver's mind. They state a general idea but leave the precise meaning to the receiver's interpretation.
16 The Overconfidence Trap The overconfidence bias is the tendency people have to be more confident in their own abilities, such as driving, teaching, or spelling, than is objectively reasonable. Below Average Average Above Average Percentage of managers (n = 300) 76% 24% Source: Montier (2006). Behaving badly. Self-reported belief in their fund-management ability relative to other fund managers For example, overconfidence can make people less cautious in their decisions, excessively trade their portfolios, and under-diversify, all of which lead to underperformance. A survey showed that most managers think they have above average analytical skills (a statistical impossibility.) Make data-driven and evidence-based decisions Corroborate claims with information from multiple sources Be more specific about predictions Perform multiple assessments of the same thing HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
17 The Base-Rate Neglect Trap In finance, investors are prone to believe that a history of a remarkable performance of a given firm is ‘representative’ of a general performance that the firm will continue to generate into the future. Thus, they overreact to salient and similar information about firms past performance such as similar consecutive earnings surprises. This usually leads to a violation of the Bayes' theorem. Widen your perspective and scope of data Think probabilistically and apply the Bayes’ theorem List down potential causes for failure of companies Avoid narrow categorizations of companies P(A|B) = P(B|A) . P(A) P(B) P(B|A) → Probability of finding a pharma company among successful IPOs P(A) → Probability of a successful IPO P(B) → Probability of company being a pharma firm P(A|B) → Probability of a successful IPO by a new pharma company Investors should use this for accurate predictions Representativeness forces us to focus on this Base-rates that are often neglected HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP Base rate fallacy, or base rate neglect, is a cognitive error whereby too little weight is placed on the base, or original rate, of possibility (e.g., the probability of A given B.)
Even though we shared some specific ways managers can guard against these traps, it’s important to remember, “the best defense is always awareness.” “Executives who attempt to familiarize themselves with these traps and the diverse forms they take will be better able to ensure that the decisions they make are sound and that the recommendations proposed by subordinates or associates are reliable.” Conclusion

More Related Content

The Hidden Traps in Decision Making

  • 1. AUTHOR: ANKIT SAXENA The Hidden Traps in Decision Making
  • 2. In making decisions, you may be at the mercy of your mind’s strange workings. Here’s how to catch thinking traps before they become judgement disaster. By John S. Hammond, Ralph L. Keeney, and Howard Raffia
  • 3. Introduction Before deciding on a course of action, prudent managers evaluate the situation confronting them. Unfortunately, some managers are cautious to a fault – taking costly steps to defend against unlikely outcomes. Others are overconfident – underestimating the range of potential outcomes. And still others are highly impressionable – allowing memorable events in the past to dictate their view of what might be possible now. 3
  • 4. Introduction These are just three of the well-documented psychological traps that afflict most managers at some point, assert authors John S. Hammond, Ralph L. Keeney, and Howard Raiffa in their 1998 article. Still, more pitfalls distort reasoning ability or cater to our own biases. Examples of the latter include the tendencies to stick with the status quo, to look for evidence confirming one’s preferences, and to throw good money after bad because it’s hard to admit making a mistake. 4
  • 5. Introduction Luckily, techniques exist to overcome each one of these problems. For instance, since the way a problem is posed can influence how you think about it, try to reframe the question in various ways and ask yourself how your thinking might change for each version. Even if we can’t eradicate the distortions ingrained in the way our minds work, we can build tests like this into our decision-making processes to improve the quality of the choices we make. 5
  • 6. Decision Traps ANCHORING STATUS-QUO SUNK-COST CONFIRMATION FRAMING ESTIMATION Page 7 Page 8 Page 9 Page 10 Page 12 Page 11 6 GROUP THINK VAGUE VERBIAGE OVERCONFIDENCE BASE-RATE Page 13 Page 14 Page 16 Page 17
  • 7. The Anchoring Trap When considering a decision, the mind gives disproportionate weight to the first information it receives. Initial impressions, estimates, or data anchor subsequent thoughts and judgements. HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP Anchors take many guises. They can be as simple and seemingly innocuous as a comment offered by a colleague or a statistic appearing in the morning newspaper. They can be as insidious as a stereotype about a person’s skin color, accent, or dress. In business, one of the most common types of anchors is a past event or trend. Use alternative starting points Think about the problem on your own Seek information from other sources Be careful of setting anchors yourself 11 99 $30 $80 How much will you bid for this wine? Think of a random number 7
  • 8. The Status-Quo Trap We naturally look for reasons to do nothing to protect our ego from damage. Breaking the status quo means taking action, which means taking responsibility, thus, opening ourselves to criticism and regret. People sometimes, for example, inherit shares of stock that they would never have bought themselves. Although it would be a straightforward, inexpensive proposition to sell those shares and put the money into a different investment, a surprising number of people don’t sell. They find the status quo comfortable, and they avoid taking action that would upset it. “Maybe I’ll rethink it later,” they say. But “later” is usually never. Never think of your status quo as your only option Would you choose the status quo, if it wasn’t the status quo? Appeal of the status quo will change with time, so keep evaluating Avoid exaggerating the effort to make a change OUTCOME VALUE GainsLosses 1 unit 1 unit 1 unit 1.31 units People give a higher weight to what they already have making them attached to their current situation and goods. Kahneman and Tversky’s prospect theory (1992) showed that people felt losses more than they felt equivalent gains and this loss aversion prompts them to stay with the status quo. 8 HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
  • 9. The Sunk-Cost Trap We often make choices that justify past choices, even when past choices no longer seem valid. Frequently, it’s because people are unwilling, consciously or not, to admit to a mistake. Acknowledging a poor decision in one’s personal life may be purely a private matter, involving only one’s self-esteem, but in business, a bad decision is often a very public matter, inviting critical comments from colleagues or bosses. If you fire a poor performer whom you hired, you’re making a public admission of poor judgment. It seems psychologically safer to let him or her stay on, even though that choice only compounds the error. Seek other perspectives Examine why an old mistake distresses you Don’t cultivate a failure-fearing culture Be on the lookout for sunk cost 9 HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
  • 10. The Confirmation Trap This bias leads us to seek information that supports our existing instinct or point of view. There are two fundamental psychological forces at work here. The first is our tendency to subconsciously decide what we want to do before we figure out why we want to do it. The second is our inclination to be more engaged by things we like than by things we dislike – a tendency well documented even in babies. Naturally, then, we are drawn to information that supports our subconscious leanings. Examine all the available evidence Assign a devil’s advocate Avoid leading questions when seeking advice Be honest with yourself about your motives A Q 4 7 A) A, 4 B) A, 7 C) Q, 4 D) Q, 7 If a card has a vowel on one side, then it must have an even number on the other side. Most people choose A and 4 because these are the cards capable of confirming the statement, but confirming evidence doesn’t prove anything – the 4 card has no ability to invalidate the hypothesis. Flipping the 7 card, however, could provide valuable disconfirming evidence – a vowel on the other side means not all cards with vowels have an even number on the other side. 10 HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
  • 11. The Framing Trap Framing bias occurs when people make a decision based on the way it’s presented, as opposed to just on the facts themselves. The same facts presented in another way can lead to different judgments or decisions. A frame can establish the status quo, introduce an anchor, highlight a sunk cost, or lead you to confirming evidence. Framing can be particularly important when assessing risk tolerance; advisors and clients alike need to make sure to develop a shared understanding of what constitutes risk and should decide how much risk is tolerable for a given client. Don’t automatically accept the initial frame Try positioning problems in a neutral, redundant way Challenge people’s questions with other frames Think hard throughout your decision making process OPTION 1: In Q3, our Earnings per Share (EPS) were $1.25, compared to expectations of $1.27 OPTION 2: In Q3, our Earnings per Share (EPS) were $1.25, compared to Q2, where they were $1.21 Clearly, option 2 does a better job of framing the earnings report. The way it is presented as an improvement over the previous quarter puts a more positive spin on the EPS number. 11 HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
  • 12. Traps in Estimating and Forecasting Making estimates about time, distance, weight and volume are familiar, and we can get good at those estimations because we can get quick feedback. However, making forecasts with uncertain events is difficult. There are three traps within forecasting: Manage overconfidence by considering extremes Examine your assumptions and get more statistics to reduce recallability Manage prudence with honesty by telling people if estimates haven’t been adjusted Think hard throughout your decision making process Overconfidence We are often overconfident about our ability to forecast. Prudence Trap We err on the side of caution when faced with high-stakes decisions. Recallability Trap Our forecasts are often influenced by our own experiences. 12 HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
  • 13. 13 Group Think Groupthink is a term developed by social psychologist Irving Janis in 1972 to describe suboptimal decisions made by a group due to group social pressures. HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP It is a phenomenon in which the ways of approaching problems or matters are dealt by the consensus of a group rather than by individuals acting independently. Essentially, groupthink occurs when a group makes faulty or ineffective decisions just for the sake of reaching an agreement. The following situations increase the likelihood of groupthink: Vague or abstract words can create confusing meanings in your receiver's mind. They state a general idea but leave the precise meaning to the receiver's interpretation. The following examples show vague or abstract words and ways to make them specific and precise: Vague Precise Many 1,000 or 500 to 1,000 Early 5 a.m. Hot 100 degrees Fahrenheit Most 89.9 percent Others Business administration students Poor student has a 1.6 grade point average (4.0 = A) Very rich A millionaire Soon 7 p.m., Tuesday Furniture An oak desk Group identity When there is strong group identity. Leader influence When a charismatic leader commands the group. Lack of knowledge When people lack personal knowledge of something or feel that other members of the group are more qualified. Cognitive load Where the group is placed under extreme stress or where moral dilemmas exist.
  • 14. 14 The Vague Verbiage Trap HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP Though vagueness often occurs unintentionally, it may also be employed as a deliberate rhetorical strategy to avoid dealing with an issue or responding directly to a question. Macagno and Walton note that vagueness "can also be introduced for the purpose of allowing the speaker to redefine the concept he wishes to use" (Emotive Language in Argumentation, 2014). The following examples show vague or abstract words and ways to make them specific and precise: Vague Precise Many 1,000 or 500 to 1,000 Early 5 a.m. Hot 100 degrees Fahrenheit Most 89.9 percent Others Business administration students Poor student has a 1.6 grade point average (4.0 = A) Very rich A millionaire Soon 7 p.m., Tuesday Furniture An oak desk Vague or abstract words can create confusing meanings in your receiver's mind. They state a general idea but leave the precise meaning to the receiver's interpretation.
  • 15. 15 The Vague Verbiage Trap A corporation’s earnings report needs to be interpreted and digested by both analysts and the market. The conference call accompanying the reports release, predominantly conducted by the CEO and CFO, conveys valuable information that facilitates this process. Word choice by managers affects information processing. In particular the use of uncertain words, such as “probably” and “maybe”, induces investors to respond less to earnings surprises. That is especially true for managers answers to analyst questions. We have established that earnings communicated by vague managers delay the responses of analysts and increase their uncertainty; they also cloud the picture for the majority of investors. These are major consequences but they do not explain why firms might hire vague managers. Could vague talk bring any benefits? The answer is “yes” in a second-best world where managers’ statements that prove to be excessive after the fact get punished. Arguably, this issue would be more pronounced for positive statements, if things later take a turn for the worse. This is especially relevant given the general tendency of analysts to issue overly optimistic forecasts (Hong and Kubik, 2003). Hence, if vague style indeed helps tone down positive expectations, we would expect to see fewer (or less) negative earnings surprises for vague managers. 1. Do managers tilt to vagueness when they have reason to do so, for example to cushion disappointing earnings when her options are coming due? 2. Our method for identifying style can be employed to study other speech characteristics. For instance, do managers differ in their propensity to use positive/negative, quantitative/qualitative, or other types of statements, and what are the capital market effects, if any, of such style differences that are identified? EARNINGS REPORT EXAMPLE Vague or abstract words can create confusing meanings in your receiver's mind. They state a general idea but leave the precise meaning to the receiver's interpretation.
  • 16. 16 The Overconfidence Trap The overconfidence bias is the tendency people have to be more confident in their own abilities, such as driving, teaching, or spelling, than is objectively reasonable. Below Average Average Above Average Percentage of managers (n = 300) 76% 24% Source: Montier (2006). Behaving badly. Self-reported belief in their fund-management ability relative to other fund managers For example, overconfidence can make people less cautious in their decisions, excessively trade their portfolios, and under-diversify, all of which lead to underperformance. A survey showed that most managers think they have above average analytical skills (a statistical impossibility.) Make data-driven and evidence-based decisions Corroborate claims with information from multiple sources Be more specific about predictions Perform multiple assessments of the same thing HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP
  • 17. 17 The Base-Rate Neglect Trap In finance, investors are prone to believe that a history of a remarkable performance of a given firm is ‘representative’ of a general performance that the firm will continue to generate into the future. Thus, they overreact to salient and similar information about firms past performance such as similar consecutive earnings surprises. This usually leads to a violation of the Bayes' theorem. Widen your perspective and scope of data Think probabilistically and apply the Bayes’ theorem List down potential causes for failure of companies Avoid narrow categorizations of companies P(A|B) = P(B|A) . P(A) P(B) P(B|A) → Probability of finding a pharma company among successful IPOs P(A) → Probability of a successful IPO P(B) → Probability of company being a pharma firm P(A|B) → Probability of a successful IPO by a new pharma company Investors should use this for accurate predictions Representativeness forces us to focus on this Base-rates that are often neglected HOW THIS TRAP CAN AFFECT YOU OVERCOMING THIS TRAP Base rate fallacy, or base rate neglect, is a cognitive error whereby too little weight is placed on the base, or original rate, of possibility (e.g., the probability of A given B.)
  • 18. Even though we shared some specific ways managers can guard against these traps, it’s important to remember, “the best defense is always awareness.” “Executives who attempt to familiarize themselves with these traps and the diverse forms they take will be better able to ensure that the decisions they make are sound and that the recommendations proposed by subordinates or associates are reliable.” Conclusion