Numerous studies have shown that on average, people make thousands of decisions each day 1. While most of these decisions are mundane (what to eat, what to wear, what Netflix show to binge on), some decisions are more significant. For example, managers are called upon to make important decisions that can have far reaching consequences such as which product to launch first or where to build a new store.
Common sense dictates that humans are rational beings who think, analyze, and evaluate situations before making decisions. In fact, many theories of economics are built upon the principle of rationality which states that “people behave in rational ways and consider options and decisions within logical structures of thought, as opposed to involving emotional, moral, or psychological elements” 2. Unfortunately, the study of economics has it all wrong. Humans, more often than not, are irrational beings.
In 1974, Kahneman and Tversky demonstrated that people are not nearly as rational as they’d like to think 3. When people face uncertainty, they rarely evaluate all relevant information or base their decisions on rational analysis. Instead, people often make decisions based on mental short cuts which could lead to foolish decisions with potentially disastrous consequences.
The stock market is a case in point. For any given year, the direction of capital markets depends on an extremely complex system of variables. Knowing that, professional investors still believe that they know what will happen. For example, fund managers charge high fees to “manage” a portfolio of stocks promising returns that are higher than the market. Unfortunately for the average investor, these funds routinely fall below the market average. A detailed study that was done over a period of 23 years showed that “actively managed funds trailed their benchmarks by an average of one percentage point a year” 4. Another study showed that for the majority of funds, the performance of a fund cannot be predicted based on its past performance, suggesting that most successful managers depend on luck as opposed to talent 5. Given this evidence, why do investors consistently give their money to managers whose performance is worse than the market?
The reason that we keep on making irrational decisions is due to what experts call a “cognitive bias” which is defined as a systematic pattern of deviation from norm or rationality in judgment 6. People often construct their own subjective reality based on how they interpret the environment around them. Therefore, a person’s construction of reality can have a large influence on their behavior 7 and cognitive biases can lead to inaccurate judgments and illogical interpretation 8. This is broadly called irrationality. While everyone thinks (or believe that they think), our thinking can sometimes be reactive, biased, or uninformed.
What then can be done to limit the damage from irrational behavior? Is there a way that we can force ourselves to be more disciplined in decision-making? In business, mitigating the risk of this bias can be achieved by basing decisions on robust evidence which can lead to better organizational results. Evidence based decision making is about “making decisions through the conscientious, explicit and judicious use of the best available evidence from multiple sources” 9.
Evidence basically means valid information. While valid information includes numbers, it may also include qualitative or descriptive data. Evidence can be obtained from scientific research, expert opinions, organizational practices, company metrics, or observations of practice conditions. For example, a business owner’s past experience of setting up a tech startup can be a source of information for what works and what doesn’t.
Basing decisions on strong evidence sounds like a valid approach. However, one must be aware of several myths that surround evidence based decision making:
Myth #1 - Evidence based decisions can only be made using numbers: Rational evidence based practice involves using the best available evidence. While numbers provide important information, evidence can come from various sources and is not only about quantitative data. Expert opinions can be an important source of information as well as the opinions of different stakeholders such as customers and suppliers.
Myth #2 - Data from one sector cannot be applied to a company from a different sector: Managers sometimes complain that the sector they work in does not have reliable information that can be used for making decisions. This is where businesses can be creative and look for other sources. Is there a different sector that can provide some direction?
Myth #3 – Basing decisions on strong evidence will always result in a positive outcome: Sadly, even decisions that are based on the best information can sometimes result in a negative outcome. The world is a complex system and this complexity can result in unforeseen events. Take COVID-19 for example which, at the time of writing this article, has completely made a mockery of the best business decisions. Evidence based decision making does not guarantee that the consequences will always be positive. However, what it can guarantee is that the best possible decision is being made given the circumstances.
While we like to think that we are a rational thinking species, the evidence strongly points to the contrary. However, by basing more of our business decisions on strong evidence, we can start walking towards the path of rationality. This would be good news to economists. Maybe their theories can then start working.
1 Sahakian, B. J., & Labuzetta, J. N. (2013). Bad moves: how decision making goes wrong, and the ethics of smart drugs. London: Oxford University Press.
2 DiRita P. (2014) Economic Rationality Assumption. In: Michalos A.C. (eds) Encyclopedia of Quality of Life and Well-Being Research. Springer, Dordrecht.
3 Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. science, 185(4157), 1124-1131.
4 Knowledge@Wharton (2011). If Index Funds Perform Better, Why Are Actively Managed Funds More Popular?.
https://knowledge.wharton.upenn.edu/article/if-index-funds-perform-better-why-are-actively-managed-funds-more-popular/.
5 Kahneman, D. (2011). Thinking, fast and slow. Macmillan.
6 Buss, D. M. (Ed.). (2005). The handbook of evolutionary psychology. John Wiley & Sons.
7 Kahneman, D., & Tversky, A. (1972). Subjective probability: A judgment of representativeness. Cognitive psychology, 3(3), 430-454.
8 Ariely, Dan (2008). Predictably Irrational: The Hidden Forces That Shape Our Decisions. New York, NY: HarperCollins.
9 Barends, E., Rousseau, D. M., & Briner, R. B. (2014). Evidence-based management: The basic principles. Amsterdam: Center for Evidence-Based Management.
Once upon a time, in a cozy suburban neighborhood, lived the Al-Meqyass…
When I worked in the public sector, benchmarking was one of the crucial…
Data visualization is a crucial aspect of data analysis, allowing users…
In my government strategy course, I present a public sector policy and…
© 2024 Meirc Training & Consulting. All rights reserved.