Overcome bias to make better decisions.

Most people act fairly rationally, at least when it comes to business. That is certainly what we were all taught in business school. The theory is that most people will act in their own self-interest, and make careful decisions based on all of the available facts. If they hear about an offer that “sounds too good to be true”, they won’t fall for it. Right?

If something looks too good to be true, it probably isn’t.

The reality, of course, is that people often do stupid things. They make poor decisions based on incomplete or inconclusive data, hunches, superstitions, or other deep-seated beliefs that don’t necessarily mesh with reality. Hundreds of thousands of people invested in timeshares long after it became clear that they were rarely a good investment.

After Hurricane Katrina, tens of thousands of people moved back into the most dangerous areas and rebuilt their homes, despite ample evidence that their homes would probably be destroyed again by an even worse storm. Bernie Madoff swindled hundreds of millions of dollars out of actors, celebrities and business executives, and many others — most of whom should have known better. They all understood that no investment can keep generating above-market returns year after year after year with no letup. But they invested anyway. And to compound the problem, many of these victims invested very large sums of money, so when Madoff’s scam collapsed, a lot of people weren’t just hurt a bit, they were wiped out.

These are just a few obvious examples of how people fool themselves. You don’t have to look far to see countless others. Just watch a few episodes of American Greed. Some of the scams are very clever, but a lot of them seem so obvious that is hard to believe these guys could get away with it. But they do, time, after time, after time.

Confirmation bias – get out of the echo chamber.

One way people fool themselves is through “confirmation bias” — once they believe something is true, they seek out evidence that supports their belief and discount evidence that says otherwise. We all do it. It seems to be hardwired into the human brain. But you can fight the urge, and if you really want to succeed in business, you’ll have to.

One way to fight confirmation bias is to gather information from a variety of disparate sources. Another is to interact with people who don’t always agree with you. Abraham Lincoln famously surrounded himself with a “team of rivals” who challenged his thinking on a wide range of issues.

On the other hand, Lyndon Johnson and Richard Nixon, two Presidents tarnished by bad decisions during the Vietnam war, surrounded themselves with people who told them what they wanted to hear.

Anchoring bias – keep an open mind to new information.

Another way people fool themselves is through “anchoring bias”, the tendency to give too much weight to data you receive very early in your decision making process.  An example is when someone wants to sell a used car. The seller will often start with a high price, to set an anchor so any future prices look very reasonable compared to the initial one. In this case the anchor is useful, at least for the seller, who is trying to maximize his sales price.

Example of avoiding these types of bias.

But now suppose you are an entrepreneur developing a new product, and someone has told you the market for your product is “huge, in the hundreds of millions of dollars”. Because you have that initial high value anchored in your mind, you will tend to reject any later information that suggests a lower value. And since this was your idea to begin with, and you are excited about it, your confirmation bias will also kick in. The end result is that it is going to be very difficult for you to change your mind, even if the objective facts don’t support your vision.

One way to counteract your inherent biases is to simply discount your market size estimates. But what if your initial estimate was correct? Then you’ve shot yourself in your own foot.

A better approach is to bring in an independent expert to analyze the market. If this expert is truly independent, this eliminates the bias problem, and provides a rational estimate that can be used for future decisions. Of course, in the real world everyone has some sort of bias, and no one is completely independent. But you can get pretty close to that ideal if you are careful.