James Langabeer, Ph.D., is a decision scientist, professor, and the Founder of Yellowstone Consulting.
Managing money can be a complex and emotional endeavor when it involves our family funds, but when it comes to those of the businesses we run, it is even more complicated. One wrong move and the company’s future outlook could be compromised. The decisions we make when it comes to our capital and strategic investments are often influenced by our biases and emotions rather than on rational and coherent strategy. Understanding the principles of behavioral finance can help executives gain insight into their own psychological tendencies and make more informed decisions. In this article, we will explore how to apply behavioral finance theory to strategic decision-making in companies and provide practical tips to combat biased thinking.
Capital And Strategic Investments
Say a healthcare industry CEO wanted to open a new facility outside her core market, and the team started with a deep dive into the socio-demographics and demand for their services across the state. That’s a great start: using data to help make choices. But when it came time to narrow down the locations, executives questioned many of the choices that were unknown to them. Familiarity bias, relationships with people in the area, and conventional wisdom on certain areas won out, and executives decided to spend millions of dollars in areas that may not have been optimal.
All businesses make strategic decisions, whether they’re about a company acquisition, new company vehicles, or building a new plant. We likely think we’re going in each time with a fresh perspective, but instead, we tend to bring our old habits and hunches into the equation. We sometimes end up with a choice that might be more automatic than contemplative. Each time you make a big choice, it’s time to reconsider your mental model.
Mental Models And Behavioral Finance
One popular definition of business strategy is that it is a pattern of decisions made over time. Investments and resource allocation involve choices and therefore influence strategy. Behavioral finance theory aims to shed light on the psychological factors that influence our purchasing and investment decisions. Emotions, feelings, memories and even subconscious beliefs can drive our choices in ways we don’t fully understand. When faced with market fluctuations or potential triggers, we tend to react impulsively and make snap judgments that may not align with our long-term goals.
Biases distort perceptions and block us from applying better decision-making models. New approaches may be muted because existing cognitive biases and emotional responses are overly expressed. Imagine Tom, a retail industry CEO, getting input and recommendations from two people: one he “likes” and one he doesn’t. Who is he more likely to trust and accept recommendations from? More than likely, he is placing more weight on the input from one over the other. To combat these knee-jerk reactions, it is important to slow down our thinking and take other steps to improve our mental models.
Cognitive Bias and Shortcuts
A bias is a distortion or error in thinking. We all want to think biases don’t impact us, but it is important to note that biases can affect people of all levels of experience, and they sometimes result in the use of shortcuts or heuristics to simplify decisions. Even sophisticated investors and business leaders can fall prey to poor decision-making when emotions take hold. Biases are a part of human nature, and recognizing this is the first step in mitigating their impact on our investment choices. Common biases you probably have heard about are confirmation, loss aversion, anchoring and availability bias. Rather than just defining the biases as many articles do, let’s explore ways to mitigate them in our decision-making processes.
Strategies For Mitigating Behavioral Bias
1. Recognize Bias with the ABC Framework
One of the best ways for executives and financial leaders to check their mental model is to try to recognize their biases. Try applying the ABC framework: activation, beliefs and consequences. Many therapists use this framework in cognitive behavioral therapy to help you question your beliefs about something that triggers specific thoughts or beliefs, such as a particular situation or scenario. If you can change that belief, you can create more positive consequences.
2. Tune Out Noise
Noise or distractions such as social media or multiple disparate voices in your inner business circle can partially cloud judgments and make it difficult to process information. Tune out noise to make better choices.
3. Forget Forecasts
When we make big financial decisions, we must consider the range of possibilities that might occur and make the best choice given those facts at that moment in time. But in the end, a forecast is often wrong. Many of us are not good at forecasting by nature. Instead, we can use forecasts to guide scenarios. Scenario planning focuses less on actual outcomes and is more about considering options, intent and possibilities that can counteract biases.
4. Set Clear Decision Goals
Setting clear decision goals is essential for staying focused on our long-term objectives. Having a concrete plan in place to measure our decisions against goals can also help remove some of the emotional aspects of decision-making. Clarity about goals and plans can keep companies focused on what truly matters and help them avoid impulsive actions driven by fear, familiarity or recency.
5. Diversify Your Leadership Team
One of the most important ways to ensure you have a well-grounded mental model is to diversify your inner circle. Diversification can reduce risk and adds balance and diversity. Cultivate leadership styles that are inquisitive, encourage questions and promote collaborative input.
6. Bring in Outside Help
Seeking the guidance of an independent and outside expert can help immensely. Outside experts provide an objective perspective and filter our decisions, sounding the alarm on irrational choices. However, for this relationship to be effective, you will need to have candid discussions about priorities and direction.
Summary
Behavior and psychology impact our decisions, but we can work to tune out the distortions. Regularly reviewing and rebalancing decisions through an after-action review can help maintain goal alignment. By recognizing these biases and implementing practical strategies to mitigate their impact, we can make more informed, and hopefully better, choices.
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