In the business world, decision-making is a crucial element in achieving success. However, executives often fall prey to cognitive biases, leading to flawed decision-making processes that can be detrimental to their businesses. These biases can arise from relying too heavily on an inside view, or from being overly optimistic, which can lead to executives overestimating benefits and underestimating costs. Such cognitive biases can result in the failure of market entry attempts, mergers and acquisitions, and large capital investment projects.
In this article, we will explore the common cognitive biases, and offer actionable insights on how executives can to avoid them, with a specific focus on market entry decision-making.
Cognitive biases and their impacts
One of the common flaws in strategic thinking is overconfidence, which refers to the tendency to be overly optimistic and overestimate one's abilities. Overconfidence can be beneficial in some situations, such as launching a new business, but it can lead to poor decisions when formulating and evaluating strategies.
Research has shown that the brain is especially overconfident in making estimates, and we tend to provide narrow ranges instead of acknowledging our uncertainty. Additionally, organizations often overestimate their core capabilities, such as the value of their brand.
Overoptimism is another issue related to overconfidence. Most people tend to be optimistic and have forecasts that are too rosy, leading to unrealistic estimates of uncertainties. This can be problematic in strategy development, as many strategies are based on uncertain estimates and scenario-planning.
To counter overconfidence, strategists should test strategies under a wider range of scenarios and consider adding 20 to 25 percent more downside to the most pessimistic scenario. Building more flexibility and options into strategies can also help companies scale up or retrench as uncertainties are resolved. Overall, strategists should be skeptical of strategies that rely on certainty, and they should consider the range of possible outcomes and the potential downside of their decisions.
Richard Thaler's "mental accounting" refers to people's tendency to treat and categorize money differently based on its source and the manner in which it's used. This bias is not limited to individual gamblers but is observed among conservative and rational corporations.
For instance, these executives are less likely to scrutinise expenses under a restructuring charge compared to the P&L, put cost caps on core businesses while spending freely on start-ups, and create new categories of spending like "strategic investment." While these categories may be subject to lesser scrutiny, they represent actual costs. Avoiding mental accounting traps requires treating every unit of currency equally, thereby ensuring investments are evaluated using consistent criteria and a skeptical eye towards reclassified spending.
People often prefer to maintain the status quo, even when it doesn't serve their best interests. This is due to a cognitive bias known as the status quo bias, which stems from a fear of loss. Research has shown that people are more concerned about the potential loss of something than they are excited about the prospect of gaining something. Status quo bias can have serious strategic implications, making it difficult for companies to shift their asset allocations or sell off underperforming businesses. To overcome the status quo bias, strategists should view all businesses as "up for sale" and subject status quo options to the same level of rigorous risk analysis as change options. This can help distinguish between options that feel flawy safe, and those that are the right course of action.
Anchoring is a cognitive bias that causes the brain to rely heavily on the first piece of information received when making estimates or decisions. For instance, if you are asked to guess the year of Genghis Khan's death after writing down the last three digits of your phone number, you are likely to guess the date that falls in the same millennium as your phone number, even if this is incorrect.
Anchoring can be a useful tool in negotiations and advertising, but it can also be dangerous when making strategic decisions. For example, assuming high nominal interest rates will persist for decades, as the UK's Equitable Life Assurance Society did, can lead to severe financial consequences.
To avoid the dangers of anchoring, strategists should take a long historical perspective and look at trends over 20 or 30 years or even longer. By doing so, they can avoid basing their decisions on recent experience and instead gain a more comprehensive understanding of the data. By not becoming anchored to the past or swayed by the anchoring tactics of others, strategists can make more informed decisions that are based on a broader perspective.
Sunk cost effect
The sunk-cost effect is a common problem in investments, and it often leads to throwing good money after bad, even when the original economic case no longer holds. The sunk-cost trap is especially tricky for executives making strategic-investment decisions. Financial institutions often face this problem over large-scale IT projects, and some European banks spent fortunes building up large equities businesses to compete with global investment-banking firms.
The challenge in avoiding this trap is that the brain is anchored at a particular amount of money, and loss aversion makes it hard to write off the sunk costs. Strategists can apply the full rigor of investment analysis to incremental investments and use gated funding for strategic investments to avoid this trap.
Despite what many might believe, the truth is that in the business world there's a strong tendency to follow the herd. From lending to the same kinds of borrowers to pursuing the same strategies, companies can find themselves conforming to the behaviour and opinions of others. This is known as the herd mentality, and it's a fundamental human trait. However, it can be a significant flaw in decision-making processes. CEOs may feel pressure to follow the herd rather than rely on their own information and analysis, especially during times of mass enthusiasm for a strategic trend.
Meta's recent announcement to introduce a monthly subscription fee for social media users to get verified on Facebook and Instagram highlights the herd instinct prevalent in the industry. The move comes shortly after Twitter's launch of the coveted blue checkmark, which was well-received by users, and released shortly after Elon Musk's acquisition of the platform. It is possible that other social media platforms may also adopt similar measures in the future.
Another common example of the herding bias is evident in the payday lending industry, where websites and product offerings show remarkable consistency. It is surprising that little differentiation exists in this segment, considering how easy it would be to develop something that stands out from the crowd.
The best strategies break away from the trend and seek out innovative ideas outside of the industry. Strategists must look to the periphery for unique sources of strategic advantage, rather than copying their most established competitors. By doing so, they can avoid being part of the herd and make informed decisions based on comprehensive analysis.
Misestimating future hedonic states
Misestimating future hedonic states refers to people's tendency to underestimate or overestimate how happy or unhappy they will be in the future when their circumstances change. Studies have shown that people tend to adjust to major changes in their lives relatively quickly, and their level of pleasure or happiness ends up being roughly the same as before.
This concept is evident in the investment banking industry's compensation trends during the 1990s. Despite ever-increasing compensation, the level of happiness among the bankers remained mostly unchanged. The same can be said for the way companies react to a loss of independence. While takeovers are often seen as the corporate equivalent of death, they can sometimes be the best move. However, frontline staff members typically resist takeovers, which suggests that people are very bad at estimating how they would feel if their circumstances changed drastically.
To avoid this pitfall, strategists should adopt a dispassionate and unemotional view in takeovers. Nonexecutives, who do not have a personal stake in the status quo, are more likely to maintain a detached view. Additionally, keeping things in perspective and not overreacting to apparent strategic threats or getting too excited by good news can help navigate crises with inevitable swings in emotions and morale.
The false-consensus effect occurs when people overestimate how many individuals share their beliefs, experiences, and views. This bias can lead to a lack of critical thinking and an inability to appreciate the diversity of opinions and experiences.
A good strategists should establish a culture of challenge, implement strong checks and balances to prevent dominant role models, and request detailed refutations instead of seeking validation for their strategy. It's crucial to acknowledge the variety of opinions and experiences and encourage open and honest communication in the workplace.
Market entry decision-making - actionable insights
Market entry is a critical decision for any business, and it can'e be stressed enough the important to avoid cognitive biases in the decision-making process. Here are some practical recommendations for market entry decision-making:
Create a reference class
One of the most important recommendations is to create a reference class, a group of similar decisions that other companies have made in the past, which yields comparative data that can be used to provide a reality check on the inside-view analysis.
In addition, objective predictors of success can be used to help create this reference class, based on statistical research showing that six factors are particularly important predictors of successful market entry: timing, scale relative to the competition, ability to leverage complementary assets, market positioning, marketing and distribution, and ease of entry. Even before companies select their reference cases, an explicit review of these factors sometimes shows that the dice are loaded against going forward.
Choose the right class of analogous cases
Choosing the right class of analogous cases becomes more difficult when executives are forecasting initiatives for which precedents are not easily found. To remedy this, planners should analyse both sets of analogous cases to provide useful insights. This includes examining the similarities and differences between the cases, and understanding the implications of the differences. Additionally, planners should consider the context of the cases, such as the industry, geography, and competitive landscape. This will help to identify the most relevant and applicable cases to use for market entry decisions. Planners should consider the potential risks and rewards associated with each case, and use this information to make informed decisions. By taking the time to thoroughly analyse both sets of analogous cases, planners can make more informed and strategic decisions when it comes to market entry.
Remove bias from analysis
It is also important for companies to remove any bias from their analysis of the entry decision. Five core issues to focus on are the value proposition and capabilities, the market's size, the competition, market share and revenue, and costs. The closer a company stays to its core capabilities and value proposition, the greater its chances of crafting a successful entry.
Companies can often be egocentric and assume that their resources and assets are the ones needed to meet the needs of the target market, that what they do well is sufficient for success in it, or that they can easily acquire any missing skills. To avoid such mistakes, companies should use the reference class to identify the key determinants of successful entries into similar markets. Companies should exercise caution and consider contractual approaches, such as joint ventures and licensing, that can help them secure missing assets.
Estimate market potential
Estimating a market's potential size typically involves categorising customers into a number of segments and then using pricing and elasticity assumptions to estimate the percentage of buyers in each category the company might capture. Two biases typically distort such estimates: optimism and anchoring and adjustment. Companies should always try to determine the life cycle stage of the business they wish to enter, as well as expand the list of possible competitors, to increase the odds of spotting unexpected threats.
Anticipate competitive responses
In addition, many companies fail to factor in the likely responses of current competitors. The best way to anticipate competitive responses is to conduct gaming exercises, with executives role-playing competitors to gain insight into their likely behaviour. Using the reference class to set reasonable bounds on market share estimates also helps.
Provide realistic cost estimates
Good cost estimates can make the difference between creating value and destroying it. The planning fallacy, the tendency to underestimate the duration and cost of any endeavour, is a common issue for businesses planing market entry. A broad reference class gives would-be entrants a realistic range of costs associated with attaining various market share levels. Cost estimates far below the realised costs of the reference class should make decision makers think again.
Balance optimism and realism
The ideal is to draw a clear distinction between those functions and positions that involve or support decision making and those that promote or guide action. An optimistic CFO could mean disaster for a company, just as a lack of optimism would undermine the visionary qualities essential for superior R&D and the esprit de corps central to a successful sales force.
"Thus, there needs to be a balance between optimism and realism—between goals and forecasts."
Make wiser investment decisions
Executives should make sure that they and their planners adopt an outside view in deciding where to invest among competing initiatives. More objective forecasts will help them choose their goals wisely and their means prudently. Once an organisation is committed to a course of action, however, constantly revising and reviewing the odds of success is unlikely to be good for its morale or performance. A healthy dose of optimism will give executives and their subordinates an advantage in tackling the challenges that are sure to lie ahead.
This means looking at the market from a different perspective, such as that of a competitor or customer, and understanding the competitive landscape. This will help to ensure that the decision-making process is informed by a comprehensive understanding of the market and the opportunities and risks associated with each potential entry point. Additionally, this approach will help to ensure that the resources allocated to each initiative are allocated in the most effective way, maximising the potential return on investment.
Overall, decision-making in the business world is a complex process, and executives must be aware of the cognitive biases that can lead to flawed decision-making processes. By understanding the common cognitive biases, such as overconfidence, mental accounting, status quo, anchoring, sunk cost effect, herding instinct, misestimating future hedonic states, and false-consensus effect, executives can be better equipped to make informed decisions. Additionally, by following practical recommendations for market entry decision-making, such as creating a reference class, removing bias from analysis, estimating market potential, anticipating competitive responses, providing realistic cost estimates, balancing optimism and realism, choosing the right class of analogous cases, and making wise investment decisions, executives can ensure that their decisions are based on a comprehensive understanding of the market and the opportunities and risks associated with each potential entry point.