Do you need to protect your business against optimism?

Avoid the sunny-side flops in business

Optimism is a blessing and a curse in business. Here’s how you can adjust for an overly sunny outlook, and avoid busting both timelines and budgets.

Humans tend to take a rosier view of the future than experience and reality justify. Some believe that bad things are less likely to happen to them – smokers assume it’s someone else, not them, who will develop cancer, and newlyweds blithely ignore the divorce rate. Psychologists call this “optimism bias”. In business and management, it can be both a blessing and a curse.

Israeli-American psychologist Daniel Kahneman won the Nobel Prize for Economics in 2002 for his work on judgement and decision-making. Kahneman is the godfather of behavioural finance, and his work shows that economics is not a field based on rational human behaviour. It is, in fact, littered with cognitive biases.

And optimism bias is one of the biggest. “Most of us view the world as more benign than it really is, our own attributes as more favourable than they truly are, and the goals we adopt as more achievable than they are likely to be,” writes Kahneman in his 2011 book, Thinking, Fast and Slow.

The perils of optimism

Optimism bias can be a great asset. It encourages us to try new things and to explore possibilities. Kahneman says optimistic people play a disproportionate role in shaping what happens in our world. “Their decisions make a difference; they are inventors, entrepreneurs, political and military leaders – not average people. They got to where they are by seeking challenges and taking risks.”

“People who are more optimistic tend to overestimate their own control and underestimate the effect of others.” Michael Cavanagh

But optimists don’t always lead a sunny life. Emotions can take over rational thought. As Kahneman says, all of us would be better investors if we just made fewer decisions.

Optimism bias also encourages people to engage in risky behaviour without taking precautions. “We have a belief that we can exercise control in a situation and to some degree that’s true,” explains Michael Cavanagh, a coaching psychologist at the University of Sydney. “But we overestimate our level of control.”

Optimism bias can also cause the overestimation of forecasts. Kahneman and his fellow psychologist, Amos Tversky, first proposed the “planning fallacy” in 1979 – the idea that we systematically underestimate the amount of time or money required for any given project.

“Overly optimistic forecasts are likely to lead to larger differences between expected and realised revenue,” says Simone Wong, a senior consultant at Frontier Economics who also works with its behavioural economics team.

Wong cites a study by David Hensher and Zheng Li, which found that for recent Australian toll roads, actual traffic volumes in the first year were on average 45 per cent below forecast levels.

“The planning fallacy describes the situation where project managers believe their own projects will be completed within a shorter time frame, for a smaller budget and with greater benefits compared to other similar projects that they are aware of,” explains Wong.

Optimists can also be tripped up by a tendency to attribute good events to internal factors and negative events to external factors.

“Similarly, they tend to attribute good events to factors which will remain permanent and negative events to causes which are temporary,” explains Cavanagh.

“People who are more optimistic tend to overestimate their own control and underestimate the effect of others and of the environment around them.”

Conversely, pessimists tend to underestimate their own control. Cavanagh says people with a pessimistic attribution style tend to be more accurate. “It’s all about the level of risk associated with failure. If you think you’re pretty good at long jump and there’s an 80 per cent chance that you’ll make it over a chasm, do you really want optimism bias on that when the consequence of not making it is death? As a pessimist, you might think that it’s going to take a bit longer to get across because you’re going to build a bridge.”

Adjusting for reality

If most humans are wired with a degree of optimism bias, how can we temper its risks in the business environment? For a start, we can pay more attention to behavioural economics, which can be used to tweak existing policy and help change people’s behaviour. Put simply, we’re more likely to do the right thing if we’re persuaded rather than pushed.

“Most of us view the goals we adopt as more achievable than they are likely to be.” Daniel Kahneman

The UK government’s “nudge unit”, officially known as the Behavioural Insights Team (BIT), is a good example. To improve public services, the team tries to change the decisions of individuals. Since it launched in 2010, BIT says it has identified public savings of £300 million.

As an example, its idea to tell late taxpayers that most people in their town had already paid saw tardy payers come onboard, and generated £30 million of extra revenue annually. And personalised texts from the UK Courts Service prompting people to pay fines reduced bailiff interventions by 150,000 and saved £30 million.

BIT worked with the New South Wales Government in 2012 to set up a similar unit in Australia. The NSW Behavioural Insights Team has applied behavioural economics to issues including tax collection, fine payments and the return to work of injured employees.

“Adding these extra disciplines to economics allows for a much richer understanding of the intricacies of human behaviour and customer decision-making,” says Wong.

An understanding of cognitive biases can also encourage decision-makers to place more weight on past outcomes when planning for the future, and so allow for the inevitability of human optimism.

“If we become aware that we do have these biases, we can put in place contingency resources or plans to recognise that we’re likely to overestimate the benefits and underestimate the costs. And therefore [we can] include some sort of uplift of our cost base and a reduction in our anticipated benefits,” Cavanagh explains. “In other words, be conservative.” 

This article is from the June issue of INTHEBLACK.

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