Reading - Part 3

Human intuition is a bad guide to handling risk. People make terrible decisions about the future. The evidence is all around, from their investments in the stock markets to the way they run their businesses. In fact, people are consistently bad at dealing with uncertainty, underestimating some kinds of risk and overestimating others. Surely there must be a better way than using intuition?

In the 1960s a young American research psychologist, Daniel Kahneman, became interested in people's inability to make logical decisions. That launched him on a career to show just how irrationally people behave in practice. When Kahneman and his colleagues first started work, the idea of applying psychological insights to economics and business decisions was seen as rather bizarre. But in the past decade the fields of behavioural finance and behavioural economics have blossomed, and in 2002 Kahneman shared a Nobel prize in economics for his work. Today he is in demand by business organizations and international banking companies. But, he says, there are plenty of institutions that still fail to understand the roots of their poor decisions. He claims that, far from being random, these mistakes are systematic and predictable.

Another source of wrong decisions is related to the decisive effect of the initial meeting, particularly in negotiations over money. This is referred to as the "anchor effect". Once a figure has been mentioned, it takes a strange hold over the human mind. The asking price quoted in a house sale, for example, tends to become accepted by all parties as the "anchor" around which negotiations take place. Much the same goes for salary negotiations or mergers and acquisitions. If nobody has much information to go on, a figure can provide comfort - even though it may lead to a terrible mistake.

In addition, mistakes may arise due to stubbornness. No one likes to abandon a cherished belief, and the earlier a decision has been taken, the harder it is to abandon it. Drug companies must decide early to cancel a failing research project to avoid wasting money, but may find it difficult to admit they have made a mistake. In the same way, analysts may have become wedded early to a single explanation that coloured their perception. A fresh eye always helps.

People also tend to put a lot of emphasis on things they have seen and experienced themselves, which may not be the best guide to decision-making. For example, somebody may buy an overvalued share because a relative has made thousands on it, only to get his fingers burned. In finance, too much emphasis on information close at hand helps to explain the tendency by most investors to invest only within the country they live in. Even though they know that diversification is good for their portfolio, a large majority of both Americans and Europeans invest far too heavily in the shares of their home countries. They would be much better off spreading their risks more widely.

More information is helpful in making any decision but, says Kahneman, people spend proportionally too much time on small decisions and not enough on big ones. They need to adjust the balance. During the boom years, some companies put as much effort into planning their office party as into considering strategic mergers.