5/12/2018 Nine cognitive biases risk managers should know - Raconteur

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BUSINESS / FUTURE OF BUSINESS RISK 2018

Nine cognitive biases risk managersshould knowBias skews perception, leading to foolish decisions – here are nine examples which riskmanagers should know about

BY CHARLES ORTON-JONES – APRIL 25, 2018

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01 Law of large numbers

The godfather of bias detection is Daniel Kahneman, who won the Nobelprize for his work. He revealed that intuition, even in matters we know a lotabout, can be awful. For example, imagine two maternity hospitals, onelarge, one small. In a week, 60 per cent of births are female. Which hospital ismore likely to be the venue? It takes time to figure out… the smaller one.Small sample sizes suffer more from deviation from the mean. Kahnemanfound people of all backgrounds failed to analyse sample sizes adequately.“Even statisticians were not good intuitive statisticians,” he concluded. 

02 Gambler’s fallacy

The original sin of investors is the tendency to assume that bad luck will becompensated by good luck. Karma. Alas, investors are frequently crippled bythe belief that the market will magically auto-correct to compensate them forprevious losses. Recently the Cboe Volatility Index, known as VIX, whichreflects market volatility, tanked. Many investors held on to their positions,praying the market would turn around. It didn’t, losing 90 per cent of its

a b v g

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value in a single day. “I’ve lost $4 million, three years’ work and otherpeople’s money,” howled one burnt gambler. 

03 Authority bias

Airline pilots wear smart uniforms for a reason. Not because they belong to amilitary order. They don’t. But because they want to imply authority. This isgreat for controlling passengers. They obey. The problem is, so do co-pilots.The writer Malcolm Gladwell in his book Outliers suggests the Korean Airflight 801 crashed because the co-pilot was too reticent to challenge the pilotabout his decisions. Post-crash, British investigators demanded the airline“promote a more free atmosphere between the captain and the first officer”to permit questioning. The air of authority can dupe the best of us. A flash ofmilitary insignia, or sharp suit, can short-circuit our normal capacityfor analysis. 

04 Conservatism bias

It’s a misconception that the right approach to risk is solely to minimise it.Risk is a vital and necessary part of life. Conservatism bias is what happenswhen this is not well understood. For example, consumers leave cash in theircurrent account rather than move to a higher yield deposit. The bias forinaction means they forgo revenue. Conservatism bias is why Blockbustervideo turned down the acquisition of Netflix for $50 million. Themanagement found it easier to do nothing than embrace risk. 

05 Triviality law

It’s exhausting to think about complex issues. Given half a chance, thehuman mind will make a break for a simpler, trivial issue to distract itself.Politics is dominated by this effect. Major issues, such as a politician’s viewon the national debt, are rarely discussed or reported. Too hard. Instead thefocus is on trivial issues, such as whether they can eat a bacon sandwich withdignity. This is a serious issue in risk. It takes effort to get people to thinkabout critical issues, such as life insurance, or the design of a nuclear powerstation. Given the chance they’ll veer off and focus on something fluffy andtrivial, to spare their grey cells. 

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06 Risk compensation

The British Medical Journal recently came out against bicycle helmets. It’snot that helmets don’t work. Fall off and you’ll be grateful your fragile skull isencased in protective plastic. Rather, the phenomenon of risk compensationnegates the benefit. Data from multiple nations shows that when cyclists feelsafer they compensate, by taking extra risks, cutting in front of cars and notlooking at junctions. Individuals with documented helmet use had 2.2 timesthe odds of non–helmet users of being involved in an injury-relatedaccident. Furthermore, mandatory helmet wearing reduced cycling, addingto negative effects. 

07 Social proof

The legendary investor Charlie Munger believed his research into cognitivebiases led him to better risk decisions. He marvelled at the beguiling powerof effects such as social proof, writing: “Big-shot businessmen get into thesewaves of social proof. Do you remember some years ago when one oilcompany bought a fertiliser company, and every other major oil companypractically ran out and bought a fertiliser company? And there was no moredamned reason for all these oil companies to buy fertiliser companies, butthey didn’t know exactly what to do and if Exxon was doing it, it was goodenough for Mobil, and vice versa. I think they’re all gone now, but it was atotal disaster.” 

08 Charm pricing

Human reaction to numbers is riddled with quirks. Richard Shotton’s newbook The Choice Factory examines the ability of businesses to harness thesebiases to influence consumers. For example, tweaking prices by a fractioncan boost sales. Discount stores use charm pricing, knocking a penny off toend in “99”. Shotton says: “I surveyed 650 consumers about their valueperception of six different products. Half saw prices ending in 99p, while theremainder saw prices a penny or two higher. Charm prices were 9 per centmore likely to be seen as good value than the rounded prices. Adisproportionately large improvement for a 1 per cent price drop.” 

09 Overconfidence bias

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Sure, we all know about Dunning-Kruger: the idea that dim peopleoverestimate their skills, while bright people doubt their abilities. But couldit be that even experts are overconfident? Alas yes, especially whenforecasting. Economist Philip Tetlock spent 20 years studying forecasts byexperts about the economy, stock markets, wars and other issues. He foundthe average expert did as well as random guessing or as he put it “as a dart-throwing chimpanzee”. Tetlock believes forecasting can be valid, but onlywhen done with a long list of conditions, including humility, rigorous use ofdata and a ruthless vigilance for biases of all types. “I believe it is possible tosee into the future, at least in some situations and to some extent, and thatany intelligent, open-minded and hardworking person can cultivate therequisite skills,” he said. It’s a challenge at the heart of the risk industry. 

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