Daniel Kahneman on the cognitive biases of entrepreneurs

Thinking Fast and Slow is a book about biases of intuition. It’s ideas are so potent that they won it’s author Danuel Kahneman a Nobel in economics. Kahneman identifies that the human brain works very well most of the time and our judgments are sound. However, it is prone to engage in a number of fallacies and systematic errors that lead to flawed opinions and adverse decision making, otherwise known as cognitive biases. We assume certain things automatically without having thought them through carefully. Kahneman calls these assumptions heuristics and, for entrepreneurs, they can be deadly. An awareness of them is the first step to countering them.

Cognitive biases - entrepreneurs

Let’s dig into the cognitive biases observed by Kahneman:

Experiencing cognitive biases

If you haven’t already heard of some of these cognitive biases then you’ve certainly experienced them. The halo effect occurs: “when the handsome and confident speaker bounds onto the stage, you can anticipate that the audience will judge his comments more favourably than he deserves”. Loss aversion explains the reason why you will be proportionately more unhappy losing a £50 note than you will be happy finding one (by about two times in fact). When people are given a choice between 1) a sure loss of £500 and 2) 50% chance to lose £1,000, the majority will prefer option 2.

The narrative fallacy (a term actually coined by Nassim Taleb) is another pertinent example. Narrative fallacies arise from human’s inevitable continuous attempt to make sense of the world and the fact that “the explanatory stories that people find compelling are simple; are concrete rather than abstract… and focus on a few striking events”. Stories are easily compounded by the halo effect when delivered by a person of perceived statute. Throw in the affect heuristic (in which people let their likes and dislikes determine their beliefs about the world i.e. your political preference determines the arguments that you find compelling) and confirmation bias (the tendency to only seek out information that supports your existing viewpoint) and you start to realise why we’re facing such challenging political times.

When it comes to entrepreneurship, we have some very obvious cognitive biases, as Kahneman explains in Chapter 24: The Engine of Capitalism.

The Optimistic Bias (and its benefits)

For Kahneman, the optimistic bias “may well be the most significant of the cognitive biases” because it can be both a blessing and a risk. He advises that you be both happy and wary if you are temperamentally optimistic.

If you are allowed one wish for your child, seriously consider wishing him or her optimism. Optimists are normally cheerful and happy, and therefore popular; they are resilient in adapting to failures and hardships, their chances of clinical depression are reduced, their immune system is stronger, they take better care of their health, they feel healthier than others and are in fact likely to live longer.

Optimistic individuals play a disproportionate role in shaping our lives. Their decisions make a difference; they are the inventors, the entrepreneurs, the political and military leaders – not average people. They got to where they are by seeking challenges and taking risks. They are talented and they have been lucky, almost certainly luckier than they acknowledge… the people who have the greatest influence on the lives of others are likely to be optimistic and overconfident, and to take more risks than they realise.

However, optimism can lead to delusional tendencies, particularly for entrepreneurs.

The chances that a small business will survive for five years in the United States are about 35%. But the individuals who open such businesses do not believe that the statistics apply to them. A survey found that American entrepreneurs tend to believe they are in a promising line of business: their average estimate of the chances of success for ‘any business like yours’ was 60% – almost double the true value. The bias was more glaring when people assessed the odds of their own venture. Fully 81% of the entrepreneurs put their personal odds at 7 out 10 higher, and 33% said their chance of failing was zero.

Kahneman tells a short story about a visit he and his wife made years ago to Vancouver Island.

We found an attractive but deserted motel on a little-traveled road in the middle of the forest. The owners were a charming young couple [who had] used their life savings to buy this motel, which had been built a dozen years earlier. They told us without irony or self-consciousness that they had been able to buy it cheap ‘because six or seven previous owners had failed to make a go of it’. They felt no need to explain why they expected to succeed where six or seven others had failed. A common thread of boldness and optimism links business people, from motel owners to superstar CEOs.

Competition neglect

Entrepreneurs sometimes see things only from their own perspective.

I have had several occasions to ask founders and participants in innovative startups a question: to what extent will the outcome of your effort depend on what you do in your firm? The answer comes quickly and in my small sample it has never been less than 80%. Even when they are not sure they will succeed, these bold people think their fate is almost entirely in their own hands. They are surely wrong: the outcome of a startup depends as much on the achievements of its competitors and on changes in the market as on its own efforts… Entrepreneurs naturally focus on what they know best – their plans and actions and the most immediate threats and opportunities such as the availability of funding. They know less about their competition and therefore find it natural to imagine a future in which the competition plays little part.

The consequence of competition neglect is excess entry: more competitors enter the market than the market can profitably sustain, so their average income is a loss. The outcome is disappointing for the typical entrant in the market but the effect on the economy as a whole could well be positive. In fact, economists Giovanni Dosi and Dan Lovallo call entrepreneurial firms that fail but signal new markets to more qualified competitors ‘optimistic martyrs’ – good for the economy but bad for their investors.

A heady brew

Courage is willingness to take the risk once you know the odds. Optimistic overconfidence means you are taking the risk because you don’t know the odds. It’s a big difference.

Taken together “the emotional, cognitive, and social factors that support exaggerated optimism are a heady brew”. Whilst this certainly appears to be true, it is optimistic tendencies that make the pursuit of entrepreneurship what it is. So what gives?

“The blessings of optimism are offered only to individuals who are only mildly biased and who are able to ‘accentuate the positive’ without losing track of reality” says Kahneman. Rational optimism appears to be what the entrepreneur must endeavor to strike – demonstrating the right balance of optimism and confidence, without becoming delusional. Not enough optimism, confidence (and luck) and you may not achieve your dreams, but too much and you risk giving in to psychological denial which is a very common cause for people going broke. That’s because they simply refuse to accept the possibility that their business ventures could fail and so they keep throwing good money after bad until the point when there’s no money left anymore.

Entrepreneurs, we don’t envy you. Good luck!

I’m Richard Hughes-Jones, an Executive Coach to CEOs and senior technology leaders.

My clients are transitional founders, CEOs and executives in high-growth technology businesses, the investment industry and progressive corporates.

Having often already mastered the technical aspects of their craft, I help my clients navigate the complex adaptive challenges associated with executive-level leadership and growth.

Find out more about my Executive Coaching services and get in touch if you’d like to explore working together. You can also read my Complete Guide to Finding the Right Executive Coach for You.

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