the shocking financial consequences of how we think

Niall Ferguson’s best-selling and televised “Ascent of Money” covers beautifully the evolution of the financial system from ancient Mesopotamia to today. It is a superb book that relates the crucial role of financial tools in the growth and decline of empires and dynasties. Ironically, in amongst this excellence, the chapter that resonates most strongly is the afterword. This is called, suitably and contemporaneously, The Descent of Money.

The theme of that chapter, and this article, is how our hard-wired thought processes cause us to make decisions with a mindset that was useful for our evolution, but that in business and finance is destructive and irrational. He lists a series of cognitive traps – ways in which we make poor decisions without realising it.

We at Latitude recognised every single one of these traps, both in ourselves and in the companies we support and review. We could also relate to the considerable damage that each one could cause if unchecked.

We illustrate some of these common traps in this article. The terminology is complex, but the ideas are simple and you will recognise every one. Even becoming aware that they exist should help avoid their destructive consequences. In the second half of this article, we attempt to go one step further in helping to steer clear of trouble and distress by proposing two well-tested answers that have been used by science and sport from their outset.

Trap 1: “Extending the present”

In this trap, the individual assumes that the present is good guide to the future; much better than examination of previous experience illustrates.

We see this at its most common in business planning where future revenues and costs are based on the present, plus or minus a small percentage. The reliable rule that we apply to such plans is that they will usually be wrong, though the future profit out-turn may end up being more-or-less the same with good management and a little luck. The alternative to extending the present – acknowledging that we are much less knowledgeable about the future than we think we are – is a more uncomfortable state of affairs; but this more realistic mindset can lead us to adopt valuable approaches such as scenario planning, which make us much readier for when the unforeseen does happen. For more details, please visit these sites:- www.bunnydirectories.com
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Trap 2: “Hindsight bias”

Hindsight Bias is the trap that causes people to attach greater probabilities to events after they happened than they did before they happened. Whereas in Extending the Present, people assume the present is a better guide to the future than it actually is, with Hindsight Bias, people over-rate the past as a reliable guide to the future.

When we attempt to learn lessons from the past, we must therefore make sure we cover the failures as well as the successes. For example, we can blithely look at many successful companies and conclude that they were much more focused in the services they offered than their more mediocre counterparts; that service or product focus is a pre-requisite for success in all market-leading companies. We could use this to conclude that we should rid ourselves of all products, services or skills except those that are part of this single core. However, if we look at the failures, we see that many of those companies were also very focused, but the successful ones were the minority that just happened to focus on the right thing. Looking at the full set of information, we would conclude that focus with no contingency plan is a high risk strategy, which more often than not will fail.

Hindsight Bias also leads us to project forward assuming that the models and mechanisms that worked in the past have a high probability of working in the future. We forget, or don’t realise, that what actually happened was the one of a myriad of possibilities that happened to be supported by the circumstances of the time. Stepping into the present, those myriad possibilities still exist and the chances of the future turning out as we project are much less likely than we think.

Trap 3: “Availability bias”

This trap causes people to base decisions on information that is to hand, usually in their memories, versus the information that they actually need, like the car driver who loses his keys at night and only looks for them under lamp posts.

We see this at its most dangerous in Board or management workshops where the day is being run on the basis that all of the important knowledge is in the room. We have even heard facilitators use this we-have-everything-in-our-heads-already as a key premise for the entire strategy that emerges.

This cognitive trap also biases us to recency and proximity – we don’t look back far enough for similar patterns or warning signs, and we don’t look far afield enough for analogous evidence of failure or success.

Trap 4: “Confirmation bias”

This trap causes people look for evidence to prove what they believe to be true, rather than looking for evidence to challenge it: why Tories read the Telegraph and Socialists read the Guardian.

We see this bias at its most damaging in investment cases for acquisitions and in business cases for investment of money and time into new ventures or projects. Even when employing a third party professional to assess the acquisition, venture or project, the investor or business manager will actually ask for affirmation or substantiation – “I’m just looking for confirmation of my hypothesis” – rather than “Challenge me and tell me where I’m wrong”.

Trap 5: “The affect heuristic”

This trap causes people to allow their beliefs and value judgements to interfere with a rational assessment of costs and benefits.

We find this most dangerous at either of two extremes: on the one hand where the decision maker is very passionate about a subject, or on the other where he is once-bitten-twice-shy.

In the former case, whilst we find it critical that managers be passionate about their products or services, this passion can blind the person to reality, and can be impossible to address without introducing a very senior individual with authority to challenge assertions with information.

In the once-bitten-twice-shy case, we have seen private equity companies abandon entire sectors following one painful loss, and refuse to entertain the most solid business case that shares even the remotest common characteristics of historic loss-makers.

Trap 6: “The problem of induction”