Avoid Cognitive Biases In Business Deals

Heuristics May Lead to Cognitive Bias

For decades, economists assumed that when making decisions people always act rationally – or within a logical and predictable decision making framework that maximizes their own economic self interests. This assumption changed beginning in the 1970s when psychologists Daniel Kahneman and Amos Tversky reshaped our understanding of human nature and rationality with experimental studies about how mental heuristics may lead to cognitive biases. Mental heuristics are mental shortcuts people instinctively make to simplify and quicken decision making. Unfortunately, Kahneman and Tversky’s research (culminating in Kahneman’s famously popular 2011 book Thinking, Fast and Slow) demonstrates that the instinctual human need or desire to use mental heuristics often leads to cognitive biases or a deviation from rationality in human judgment.

Cognitive Biases Common in Business Sales

In order to process the plethora of daily information that bombards our minds, humans employ heuristics as a natural way to spare their brain the need to endlessly think about and agonize over daily decisions. Psychologists theorize that people use a concept called attribute substitution, or replacing complex questions with simpler questions as a way to quicken their daily decisions. Additionally, people may use effort reduction which is a nice way of describing cognitive laziness or reducing the mental effort required to make choices. Buyers and sellers of businesses are not immune from cognitive biases, which may cause obstacles and distortions to many different aspects of business sales. Let’s define and explore common cognitive biases in business sales, and how to avoid emotional ‘gut-driven’ decision marking in favor of a logical ‘data driven’ approach when buying or selling a business. 

Loss Aversion

Loss aversion occurs when the emotional impact of losing an item of value is greater than the emotional impact of gaining the equivalent item of value. The emotional impact induces people to avoid taking the loss at all, even when it is against their own economic self-interests to do so. Indeed, Kahneman and Tversky’s research shows that people feel the impact of a loss twice as much than the impact of an equivalent gain. In business sales, loss aversion may negatively impact a business owner’s decision to sell their business below their own original purchase price or start-up costs. Business values change over time, and if a business has significantly less sales and owner benefit than at a previous point in time, its value may go down. The business owner’s loss aversion to ‘taking a loss’ on their initial investment should be irrelevant.

Choice Overload

The cognitive bias of choice overload occurs when too many options can overwhelm the decision maker and distort a rational decision making framework. More choices may lead to cognitive bias since there are more opportunities for the decision maker to agonize over and fear regretting their decision. Buyers of businesses sometimes experience choice overload when they have too broad of a search criteria for possible acquisition targets. By filtering out businesses that are not in their price range, geographic area, and industry type, potential buyers are less likely to suffer from choice overload and more likely to find a business that is a good fit. Otherwise the large amount of businesses to choose from may distort their decision making framework. Clearly focusing on a handful of sound business opportunities avoids choice overload.

Endowment Effect

The endowment effect is when people endow or value their own possessions more highly than they would value the same possessions if owned by another party. This naturally leads to an illogical outcome since an item’s objective value has no relationship to the identity of its owner. When selling a business, some business owners improperly fall for the endowment effect when they overvalue their own business. Business owners should always seek an objective business evaluation from a professional business broker that factors in the unique aspects and competitive advantages of the business that will remain intact after the sale. The pervasiveness of the endowment effect in economics and human behavior is well documented and should give business owners pause before attempting to value their own business.

Anchoring Bias

  • Anchoring bias occurs when a decision maker uses what may be an irrelevant reference point (either numerical or non-numerical) which alters their decision.
  • In a famous experiment demonstrating the extreme lengths to which anchoring bias adversely affects decision making skills, Kahneman and Tversky asked study participants to name the number of African countries in the United Nations.
  • Before giving their answers, the participants were shown the results of a roulette wheel predetermined to stop on 10 or 65.
  • The participants’ answers to the original question were significantly altered by whether they were shown the (totally irrelevant) lower or high number.
  • The cognitive bias of anchoring occurs frequently for both buyers and sellers of businesses.
  • Buyers often anchor themselves to asking prices of other businesses that may seem similar but in fact have different characteristics from a business of which they are contemplating a bid.
  • Business owners may anchor themselves to a price that a neighboring business received or to a price that may have been informally offered for their business several years ago.
  • The anchored price may be significantly less or more than what the business is currently worth, and should have no bearing on an objective valuation approach.

Heuristics or mental short cuts are a normal part of human life and everyday existence. As Daniel Kahneman and Amos Tversky showed us, heuristics alter our judgments and may lead to cognitive biases such as loss aversion, choice overload, the endowment effect, anchoring, and many more. Both buyers and sellers of businesses should ‘think slow’ and reduce their cognitive biases in order to achieve optimal outcomes.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.