Menu Close

Business & Psychology

THE GROWING TREND OF JUDGMENT AND DECISION MAKING

by Craig R.M. Mckenzie

Psychology is the scientific study of human behavior, so it should come as no surprise that psychology has been employed in business settings for a long time. Experimental psychology began in 1879, and soon after that – in 1911 – Coca-Cola hired psychologist Harry Hollingworth to conduct laboratory experiments to see whether, as alleged by the U.S. government, the caffeine in CocaCola syrup was deleterious to human mental and motor performance. It wasn’t. Since then, the role of psychology in business has expanded and evolved, but its relevance has increased sharply in the past 30 years, partly because of research on the psychology of judgment and decision making (JDM).

JDM researchers are broadly concerned with how people seek, interpret and combine information when making judgments and choices. Although determining how people ought to make judgments and decisions in real-world settings can be tricky, important situations exist in which people make systematic errors, or at least depart from traditional economic theory. The ubiquity of intuitive judgments and decisions in business, combined with the apparent fallibility of the processes, has led to an explosion of research on business-related topics. What follows is a brief description of some of the myriad ways in which psychology currently influences marketing, management, finance, accounting and operations management.

MARKETING

Because the marketing subtopic of consumer behavior is concerned with how consumers make choices, JDM research plays a central role. For example, in contrast to what standard economic theory would predict, consumers can be worse off when given more options. Although consumers are drawn to situations with many options, they are less likely to make a purchase (i.e., more likely to postpone the decision) and less likely to feel satisfied with their choice if they do make a purchase. This has been shown in laboratory studies, in grocery stores and even using retirement plans that varied the number of investment options.

Furthermore, although you might think that carefully considering your options will lead to better choices, this is not always so. For preferences that are difficult to verbalize (e.g., why you like a flavor of jam, a painting or a piece of music), consumers are less likely to make a satisfying choice if they analyze the reasons for selecting each candidate beforehand. In this case, analysis leads the consumer to give more weight to the reasons that are easily verbalized, which, in turn, can affect the quality of the decision and subsequent satisfaction. Relatedly, recent evidence indicates that when consumers make decisions about relatively complex products, such as which car to purchase or which apartment to rent, unconscious deliberation – being distracted before making the choice – leads to better decisions than conscious deliberation.

Market share can also be affected in surprising ways. Imagine that two external hard drives, A and B, are competing for market share. A has a larger storage capacity (500 GB vs. 250 GB) and a higher price ($120 vs. $80). A third external drive, C, is introduced into the market. What will happen to the market share of A and B? No standard economic account would predict that the market share of either A or B will increase. But it can. If C has a storage capacity of 400 GB and costs $130 – i.e., it is worse than A on both dimensions, but not by B – market share of A will increase. Although C is a hard drive almost nobody wants, its existence provides reasons to purchase A: it’s bigger and cheaper than C, whereas B is only cheaper than C. The result is that the popularity of A increases. Also of interest is that consumers exhibit “extremeness aversion;” that is, they prefer products with dimensions (e.g., price) that fall somewhere in the middle. For example, Williams-Sonoma was able to increase sales of its $275 breadmaker by introducing a second, slightly larger model at a price of just over $400.

MANAGEMENT

Psychology might permeate management more than any other broad topic in business. In the context of decision making, groups are, in theory, ideal because group members provide a rich source of knowledge and ideas that any individual alone does not have. This is especially true when managers select a group to be diverse, such as a cross-functional team. Nevertheless, “groupthink” – the tendency of group members not to challenge the prevailing opinion of the group, resulting in poor decisions – is well known. John F. Kennedy’s decision to invade Cuba is a prime example. However, poor group decisions occur not only because we are deeply ingrained not to upset the group (or our boss!), but also because our otherwise independent opinions quickly become influenced by others’ opinions. When estimating an uncertain quantity (such as next quarter’s revenues), even numbers known to be random influence people’s estimates. When the provided estimate comes from someone else in the group, the effect is even larger. Because independence of opinions is so important to the quality of group decisions – and is so quickly reduced in group settings – managers must take care to encourage and maintain independence.

rbj-2009-business-psychology-chairs

For example, brainstorming can be done individually before meeting as a group. Or since senior members of the group are less likely to be influenced by junior members’ opinions than vice versa, junior members could give their opinions first. Also important is that employees feel comfortable, and not be punished by the group, when they express different views. At the individual level, managers need to avoid the natural temptation to surround themselves with people similar to themselves, and they need to ensure that those around them feel comfortable expressing divergent views. Indeed, this describes JFK’s decision making process during the Cuban Missile Crisis, which was handled successfully

Managers are constantly challenged to motivate employees. There is an important distinction between extrinsic motivation and intrinsic motivation. The former is a desire to do a job well in order to achieve an external (usually monetary) reward, whereas the latter is a desire to do a job well because it feels good to do so. Evidence indicates that external rewards can undermine intrinsic motivation. For example, imagine two people who do the same job (perhaps at different companies), but one makes a lot of money and the other makes a little money. If the one who makes a lot of money were asked why she chooses to work at her current job, “because I make a lot of money” – an external reason – might come to mind. However, the person earning less cannot explain her own behavior in this way and may instead think of an internal reason such as “I must really like my job.” Because external rewards are an obvious and compelling explanation for behavior – even for one’s own behavior – they can overshadow intrinsic motivation for work. Consequently, many companies try to deemphasize monetary rewards and instead design jobs and a work atmosphere that encourages intrinsic motivation.

FINANCE

rbj-2009-business-psychology-finance

The area of behavioral finance has grown rapidly in the past two decades. Stock market research indicates that people trade much more than would be expected by standard economic theory, perhaps due to overconfidence on the part of both buyers and sellers. Additionally, investors tend to hold on to losing investments too long and sell winning investments too early, a pattern that may be due to loss aversion, the notion that people are more sensitive to losses than to gains. They also fall prey to herding behavior, basing their choices on what others have chosen.

U.S. workers’ ability to save for retirement has recently become an important issue because of increased reliance on 401(k)-type plans rather than traditional pension plans. Under 401(k)-type plans, employees must decide how much of their monthly income to save and how to invest their savings. Therefore, most private-sector employees are now responsible for saving for their own retirement. And they do not seem to be saving enough. Some believe that a retirement crisis is the U.S.’s next financial crisis.

Several psychological reasons might cause this, such as procrastination and placing too little value on the future (which has a strong tendency to become the present at some point). However, another important factor is whether participation in a retirement plan is the default. That is, whether employees are automatically enrolled in a plan unless they actively opt out, or are not enrolled in a plan unless they actively opt in, makes a big difference in retirement plan participation because people tend to stick with whatever the default is. Indeed, because so many employees were not participating at all in retirement plans, the Pension Protection Act was passed in 2006 to make it easier, from a legal perspective, for firms to automatically enroll employees.

It is surprising that default effects are so strong given that so much money is at stake and that the cost of opting in (in terms of time and effort) is small. Some researchers have suggested that defaults may be seen as a kind of implicit recommendation. In the case of retirement plan participation, the reasoning goes like this: “if human resources thought it was important to participate, why would they make it difficult (by having to opt-in)?” Another reason why many people do not save enough is that they do not understand how savings grow over time. They believe it grows linearly, rather than exponentially, which leads them to massively underestimate the cost of waiting to save.

And do people invest their savings properly? Portfolio theory prescribes holding a stock portfolio that is diversified across industries and countries. Novice investors – i.e., most workers these days, because of the prevalence of 401(k)- type plans – tend to have a “home bias;” that is, they invest in a disproportionate number of funds from their home country. They also use a 1/N heuristic for diversifying: if three types of investments are available, people often contribute one-third of their savings to each. Indeed, if mainly stock funds are offered, most contributions will go to stocks; and if a majority of interest funds are offered, most contributions will go to interest-bearing securities. Allocations are driven largely by how the problem is presented and not by considerations of expected risk and return.

An important concept underlying investments is the equity (or risk) premium: due to risk aversion, the expected return on a risky prospect is greater than that of a riskless prospect. Students of finance should take note that how people perceive risk, not necessarily the objective statistics regarding variance, is key. Recently, for example, it has been proposed that decisions involving risk are driven by emotion, or how the decision maker feels at the time of decision, and that this emotion can override rational considerations of the severity and likelihood of outcomes. Some people refuse to board an airplane, not because they do not understand the relevant statistics, but because of how they feel at the time of the decision. Consider again the typical investor who is not diversified enough due to home bias. Although investing some savings in a foreign, unfamiliar index fund might reduce risk, it undoubtedly feels more risky.

ACCOUNTING

When determining the fairness of a firm’s financial statements, auditors sample information from the firm’s records and make probability assessments and probabilistic inferences. For example, auditors might provide a confidence interval regarding the firm’s true account balance based on sample data, or they might estimate the probability (risk) that the true balance exceeds a specified criterion. When people, including auditors, report high confidence (e.g., 90 percent) intervals, their intervals tend to be much too narrow. That is, the intervals contain the true account value much less often than 90 percent of the time, indicating overconfidence. Compared to novices, experts (e.g., auditors in an auditing situation) report intervals that are better centered on the true value, but are also narrower, and the net effect is similar levels of overconfidence regardless of expertise.

Auditors also appear to be influenced by irrelevant information when they report intervals. In a laboratory experiment, senior auditors were asked to provide an interval for a current-year item after being presented with previous years’ verified amounts and the current year’s unverified amount. The intervals were influenced by the current year’s unverified amount, although they should not have been. As mentioned in the discussion of management, such anchoring effects are common; even random numbers influence judgments.

Moreover, although auditors frequently rely on sample evidence, evidence indicates that they are not as sensitive to sample size as they ought to be. Again, this phenomenon is easily demonstrated outside of auditing situations. Auditors also tend to overestimate conjunctive probabilities (how likely is X and Y?) and underestimate disjunctive probabilities (how likely is X or Y?), just as most people do. One explanation for this is that a conjunctive probability is usually smaller than the probability of each of X and Y separately, and these probabilities serve as an anchor, resulting in estimates that are too high. For disjunctive probabilities, the separate probabilities are usually lower, leading to estimates that are too low.

OPERATIONS MANAGEMENT

Here, the focus is on ensuring that customer needs are fulfilled and that company activities are completed in a timely manner while minimizing waste. Although there has been some application of psychology to the management of queues, operations management has historically been concerned with optimization and has paid relatively little attention to behavioral issues. However, because of the increasing number of technology-intensive companies in which knowledge workers make decisions and judgments about products, processes and projects, behavioral operations is gaining ground.

Imagine that your company has invested $10 million in developing a new product that looks like it may be inferior to a competitor’s newly released product. You need to spend only about $1 million more in order to complete the product. Should you invest the additional money? Decisions about whether to continue investing in projects should be based on future costs and benefits, not on how much has already been spent. That is, the issue is whether you will profit more than the $1 million that finishing the project will cost. Any arguments based on the $10 million already spent – the sunk costs – should be ignored. However, people have a tendency to honor sunk costs when making such decisions, perhaps due to a deeply felt (and in this case, over-generalized) need not to waste money.

People also chronically underestimate how long projects will take to complete. A product delay announcement decreases the market value of a firm by 5 percent, which may be in excess of $100 million for some industries. A recent explanation of this underestimation phenomenon is that people base their estimates on their memories of how long similar past events took, but these memories are systematically biased in the direction of underestimation. This, in turn, leads to underestimating how long future projects will take. One way to alleviate this problem is to record how long projects take rather than to rely on memory when making estimations.

A behavioral perspective is also being used to study other operations phenomena. For example, the “bullwhip” effect is a classic problem confronting supply chains. As demand for a product moves up the chain from the consumer toward the manufacturer, the demand becomes more and more erratic. Some researchers have argued that cognitive limitations and an inability to coordinate are causes of the effect, which results in significant supply chain waste and associated environmental costs.

In conclusion, psychology is having an ever-increasing impact on business, and for good reason: informal judgments and decisions are ubiquitous in business, and understanding and improving them is important. And formal processes (e.g., decision analysis) are not immune, either. Judgments often have to be made about which data to include in an analysis, and the severity and probabilities of future outcomes sometimes need to be estimated. Moreover, business is not the only area feeling the effects: JDM research is also influencing other applied areas such as medicine, law and public policy, and it continues to influence all the social sciences. Because many of the areas of business discussed here have only begun to be mined for interesting and important behavioral phenomena, it’s likely that the impact of JDM on business will only continue to grow

REFERENCES

Arkes, H. R., & Blumer, C. (1985). The psychology of sunk cost. Organizational Behavior and Human Decision Processes, 35, 124-140.

Benartzi, S., & Thaler, R. H. (2001). Naïve diversification strategies in defined contribution plans. American Economic Review, 91, 79-99.

Dijksterhuis, A., Bos, M. W., Nordgren, L. F., & van Baaren, R. B. (2006). On making the right choice: The deliberation-withoutattention effect. Science, 311, 1005-1007.

Gino, F., & Pisano, G. (2006). Behavioral operations. Unpublished manuscript, Harvard Business School.

Hendricks K. B., & Singhal, V. R. (1997). Delays in new product introductions and the market value of the firm: The consequences of being late to the market. Management Science, 43, 422 – 436.

Huber, J., Payne, J. W., & Puto, C. (1982). Adding asymmetrically dominated alternatives: Violations of regularity and the similarity hypothesis. Journal of Consumer Research, 9, 90-98.

Iyengar, S. S., & Lepper, M. R. (2000). When choice is demotivating: Can one desire too much of a good thing? Journal of Personality and Social Psychology, 79, 995-1006.

Janis, I. L. (1972). Victims of groupthink. Boston: Houghton Mifflin Company.

Loewenstein, G. F., Weber, E. U., Hsee, C. K., Welch, N. (2001). Risk as feelings. Psychological Bulletin, 127, 267-286.

Madrian, B. C., & Shea, D. F. (2001). The power of suggestion: Inertia in 401(k) participation and savings behavior. Quarterly Journal of Economics, 116, 1149-1187.

Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7, 77-91.

McKenzie, C. R. M. (2003). Rational models as theories – not standards – of behavior. Trends in Cognitive Sciences, 7, 403-406.

McKenzie, C. R. M., & Liersch, M. J. (2009). Misunderstanding savings growth: Implications for retirement savings. Unpublished manuscript, Rady School of Management.

McKenzie, C. R. M., Liersch, M. J., & Finkelstein, S. R. (2006). Recommendations implicit in policy defaults. Psychological Science, 17, 414- 420.

McKenzie, C. R. M., Liersch, M. J., & Yaniv, I. (2008). Overconfidence in interval estimates: What does expertise buy you? Organizational Behavior and Human Decision Processes, 107, 179-191.

Odean, T. (1999). Do investors trade too much? American Economic Review, 89, 1279-1298.

Roy, M. M., Christenfeld, N. J. S., & McKenzie, C. R. M. (2005). Underestimating the duration of future events: Memory incorrectly utilized or memory bias? Psychological Bulletin, 131, 738-756

Shefrin, H., & Statman, M. (1985). The disposition to sell winners too early and ride losers too long: Theory and evidence. Journal of Finance, 40, 777-790.

Smith, J. F., & Kida, T. (1991). Heuristics and biases: Expertise and task realism in auditing. Psychological Bulletin, 109, 472- 489.

Wilson, T. D., Lisle, T. J., Schooler, J. W., Hodges, S. D., Klaaren, K. J., LaFleur, S. J. (1993). Introspecting about reasons can reduce post-choice satisfaction. Personality and Social Psychology Bulletin, 19, 331- 339.