Cognitive Biases and Risk Management
Cognitive bias relates to the way a particular person can understand events, facts and other people, which is based on their intuitions, beliefs or experiences and may not actually be reasonable or accurate. Risk managers should be aware of and account for this bias as it can lead to poor business decisions and outcomes.
What are heuristics and why do they matter?
The pioneer of bias detection is Daniel Kahneman, who won the Nobel prize for his work. His major finding was that people use a number of heuristics to evaluate information, heuristics meaning rules of thumb or intuitive judgments. These heuristics can be useful shortcuts for thinking, but there are biases that may lead to inaccurate judgments in some business situations. Kahneman revealed a lot about the human mind in his book Thinking Fast and Slow. Some interesting heuristics include:
Attention and Effort
We are naturally drawn to solutions that use as little mental effort as possible.
Faith in information
We are insensitive to both the quality and the quantity of the information that gives rise to impressions and intuitions.
The law of least effort
We place too much faith in our intuition without thinking it through. For example consider the following puzzle outlined in Kahneman’s book:
A bat and a ball cost €1.10.
The bat costs €1 more than the ball.
How much does the ball cost?
Many intuitively give the answer 10 cent, when in fact if you think it through, the answer is 5 cent.
Law of large numbers
We have a strong bias towards believing that small samples closely resemble the population from which they are drawn.
The science of availability
The ease with which we can think of examples is often used to judge the frequency of events.
Availability, emotion, and risk
We try to simplify our lives by creating a world that is much tidier than reality; in the real world, we often face painful tradeoffs between benefits and costs.
Less is more
Adding detail to scenarios makes them more persuasive, but less likely to come true.
How to account for this in risk management processes:
Training on cognitive bias
A company can train their decision makers to recognise cognitive biases in decision making, enabling them to recognise and account for these biases when making business decisions.
Challenging bias
Decision makers should critically consider the following when making a decision:
- The quality and quantity of underlying data and assumptions used in scenario testing.
- Whether there are any factors that may have been missed.
- Whether too much weight is being placed on certain factors.
- Whether certain information is being discounted because it doesn’t support the overall view.
- Whether all aspects of the trade off between benefits and costs have been considered.
Accounting for cognitive bias in decision making can aid in better decision making and positive business outcomes.