Biases in decision-making: A guide for CFOs

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When it comes to making decisions, human beings have built-in biases. So do companies and other organizations. In any number of ways, these biases can stall, skew, or deny the kind of clear-sighted decisions that are at the heart of strategic management. To effectively tie strategy to value creation, management should make tangible efforts to overcome these biases.

The late Nobel Prize–winning psychologist and economist Daniel Kahneman laid the foundation for what we now call behavioral economics and behavioral finance. Drawing on Kahneman’s insights, a group of McKinsey colleagues has proposed (or adopted from others) a number of techniques to help organizations understand and improve their decision-making in resource allocation. In this article, four common biases that can affect organizational decision-making, along with some potential remedies are discussed.

1. Groupthink.  Groups of decision-makers tend to engage in groupthink, an overemphasis on harmony and consensus. This can get in the way of examining all the options objectively, leading to weaker—and sometimes disastrous—decisions.  A variation of this bias occurs when participants don’t speak up because they feel the subject under discussion does not fall under their area of responsibility or expertise.  The weight of evidence strongly supports that decisions are better when there is rigorous debate.  The key ingredient is to depersonalize debate and make it socially acceptable to be a contrarian. Here are some useful techniques:  Assign a devil’s advocate.  Bring diverse perspectives to the discussion.  Encourage debate with secret ballots.  And set up a red team–blue team activity for large investments.
2. Confirmation bias and excessive optimism.  Confirmation bias is the tendency to look for evidence that supports your hypothesis or to interpret ambiguous data in a way that achieves the same result.  Overoptimism is the tendency to assume that everything will go right with a project, even though past projects tell us that such smooth outcomes are rare.  Some of the techniques used to overcome groupthink, such as the use of opposing red and blue teams, can help here. The simplest approaches are to avoid developing hypotheses too early in the process and to actively look for contrary evidence. Other potential correctives for confirmation bias and overoptimism include the following two methods:  Conduct a premortem.  And take the outside view.
3. Inertia (stability bias).  Inertia, or stability bias, is the natural tendency of organizations to resist change. One study found that spending allocations across business units among the companies it studied were correlated by an average of more than 90 percent from year to year. In other words, the allocation of spending to business units essentially never changed.  The solution to inertia bias is relatively straightforward. Rank initiatives across the entire enterprise by potential value creation. In addition, ensure that the budget you are building is rooted in the current strategic plan, not last year’s budget.
4. Loss aversion.  Research shows that most executives are loss averse and unwilling to undertake risky projects with high estimated present values. The primary solution to overcoming loss aversion is to view investment decisions based not on their individual risk but on their contribution to the risk of the enterprise as a whole.  To be most effective, companies also should encourage middle-level managers and other employees to propose risky ideas.