ABSTRACT. Decision makers have a strong tendency to consider problems as unique. They isolate the current choice from future opportunities and neglect the statistics of the past in evaluating current plans. Overly cautious attitudes to risk result from a failure to appreciate the effects of statistical aggregation in mitigating relative risk. Overly optimistic forecasts result from the adoption of an inside view of the problem, which anchors predictions on plans and scenarios. The conflicting biases are documented in psychological research. Possible implications for decision making in organizations are examined.
KEY WORDS decision making; risk; forecasting; managerial cognition
The thesis of this essay is that decision makers are excessively prone to treat problems as unique, neglecting both the statistics of the past and the multiple opportunities of the future. In part as a result, they are susceptible to two biases, which we label isolation errors: their forecasts of future outcomes are often anchored on plans and scenarios of success rather than on past results and are therefore overly optimistic; their evaluations of single risky prospects neglect the possibilities of pooling risks and are therefore overly timid. We argue that the balance of the two isolation errors affects the risk-taking propensities of individuals and organizations.
The cognitive analysis of risk taking that we sketch differs from the standard rational model of economics and also from managers' views of their own activities. The rational model describes business decisions as choices among gambles with financial outcomes, and assumes that managers' judgments of the odds are Bayesian, and that their choices maximize expected utility.
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