Money and Finance

Smart People, Dumb Decisions - By Michael Mauboussin

Originally found via Simoleon Sense.

If you ask people to offer adjectives that they associate with good decision makers, words like “intelligent” and “smart” are generally at the top of the list. Yet, history contains plenty of examples of smart people who made poor decisions as the result of cognitive mistakes. These mistakes can have horrific consequences, from the space shuttle Columbia disaster to the scores of bank failures across the United States since the start of the 2007 recession. But faulty decision making is also avoidable. Every day, research is offering new insights into the decision- making process. A science of choice is emerging, and the good news is that everyone, from students to stockbrokers, can learn how to make better decisions.

Smart people make poor decisions because the mental software that we humans inherited from our ancestors isn’t designed to cope with the complexity of modern day problems and systems. In short, smart people, like everyone else, face two major obstacles to making good decisions. The first obstacle is the brain, which evolved over millions of years to make decisions unlike what we face in modern life. The second obstacle is the growing complexity of the world in which we live.

Overconfidence: The Biggest Factor in Poor Decisions

Our natural decision-making process makes us vulnerable to certain mental mistakes. One example is what psychologists call the “inside view,” which explains that we consider problems by focusing on a specific task, use information that is close at hand, and make predictions based on that narrow and unique set of inputs. This approach is common for all forms of planning and almost always paints too optimistic a picture.

Overconfidence, in one form or another, is central to the inside view, and can lead to three illusions that can derail decisions: the illusion of superiority, the illusion of optimism, and the illusion of control.

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While people are notoriously poor at guessing when they’ll complete their own projects, they’re pretty good at guessing when other people will finish. In fact, the planning fallacy embodies a broader principle. When people are forced to look at similar situations and see the frequency of success, they tend to predict more accurately. If you want to know how something is going to turn out for you, look at how it turned out for others in the same situation.

Daniel Gilbert, a psychologist at Harvard University, has pondered why people don’t rely on the outside view more often: “Given the impressive power of this simple technique, we should expect people to go out of their way to use it. But they don’t.” The reason is that most people think of themselves as different, and better, than those around them.

Even people who should know better forget to consult the outside view. Now that you are aware of how the inside-outside view influences the way people make decisions, you’ll see it everywhere. In the business world, it will show up as unwarranted optimism for how long it takes to develop a new product, the chance that a merger deal succeeds, and the likelihood a portfolio of stocks will do better than the market. In your personal life, you’ll see it in the parents who believe their seven-year-old is destined for a college sports scholarship, debates about what impact video games have on kids, and the time and cost it will take to remodel a kitchen.

How to Incorporate the Outside View into Your Decisions

Unlike the inside view, the outside view asks if there are similar situations that can provide a statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and, if so, what happened. The outside view is an unnatural way to think precisely because it forces people to set aside all of the cherished information they have gathered. Regardless, it can create a very valuable reality check for decision makers.

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Related book: Think Twice

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