How Cognitive Biases Affect Risk Perception

The basis for effective risk management is helping decision-makers running the business make informed decisions under uncertainty that enhance enterprise performance. But what happens if this decision support process is riddled with significant cognitive biases? Simple answer: suboptimal decision-making.

Cognitive biases or flaws in thinking or judgment influence our decisions and beliefs and are an inherent part of human decision-making. Left unchecked, these biases often lead us to misinterpret information and draw irrational, subjective conclusions that can be costly.

Since most business decisions are made under conditions of uncertainty, risk managers need to understand how behavioral biases affect risk perception and influence sound decision-making.

There are over 100 cognitive biases that influence our decisions and distort our perception of reality. In this article, I will discuss the 3 most common biases that affect organizational decision-making, including potential remedies. I will touch on other biases in future articles.

Confirmation Bias

We tend to selectively search for information or confirming evidence that justifies our currently held beliefs and reject new ideas that do not fit our preconceptions. For example, consider a shift in the government’s immigration policy that negatively impacts your organization’s core target market, thus requiring you to update revenue targets and adapt your strategy.

The CFO preparing a revenue forecast and the risk manager assessing applicable risks might selectively focus on historical positive immigration data, assume existing revenue targets will be achieved, and ignore or discount potential negative signals from the policy shift.

To overcome or reduce the impact of confirmation bias on decision-making:

• First, acknowledge that the bias exists, then question your pre-existing decision-making process and beliefs. What factors influence or have helped shape your thinking or judgment?
• Encourage, respect, and value diverse perspectives. When the team is composed of people with different educations, training, experiences, and personalities, they are unlikely to all reach precisely the same conclusion, regardless of all looking at similar evidence or information.

Anchoring Bias

The tendency for decision-makers to place high value on the first set of information they receive, often a number, then anchor their decisions on that information, resulting in flawed risk assessment and erroneous conclusions. For example, a project manager is planning for a new office relocation and renovation project. A similar project was completed for another business unit a few years ago at a total cost of $5MM. The assumptions that were valid at the time no longer apply today.

Because of the anchoring effect, the project manager uses the $5MM total cost as a benchmark to risk assess and plan for the new project, even though new information indicates the total project costs will exceed this figure due to project scope changes and unforeseen challenges. This overreliance on the anchor results in cost overruns and budget constraints, potentially causing project completion delays.

To overcome anchoring bias, recognize the anchor, how it guides and constrains your thinking, and consider multiple perspectives and reference points to foster critical thinking and problem-solving.

Optimism Bias

Overly optimistic decision-makers tend to overestimate the likelihood of positive outcomes or benefits and underestimate costs, despite statistical evidence that not all business initiatives are successfully executed according to plan.

A classic example is an organization launching a new product with a strong belief that it will capture a sizable market share and gain a competitive advantage. Top management assumes that the product offering is what the market has been waiting for.

Hockey stick plans and forecasts that are unrealistically close to best-case scenarios and detached from the statistics of similar initiatives are prepared. Only after the launch does reality set in. The product fails to satisfy customer preferences and capture market share, leading to its discontinuation.

To overcome optimism bias, identify and evaluate statistics of similar cases, and use the statistics to generate a baseline prediction or make the necessary adjustments. Taking this outside view helps you move beyond focusing only on information that is in front of you, but also consider all the distributional information that is available.

Another remedy is conducting a premortem. At the beginning of a project, team members are asked to imagine it is a year into the future, the project plan has been implemented in its current form, but the project has failed, and they must identify the reasons for the failure. The idea is to encourage objective criticism of the plan, eliminate biases, and identify threats not considered at the beginning.

Since biases are an inherent part of our thinking process, we cannot eliminate them, rather, we can reduce their effects on our decisions.

Are you aware of the cognitive biases causing you to make irrational, subjective decisions?