This is the first installment in a series of posts on Decision Errors, or biases that tend to cloud our decision making process. The objective of this series is to highlight challenges in making clear decisions, and then point to tools or processes to help us overcome these biases.
The first bias we will address is the Ambiguity Effect. Stated formally in Wikipedia…
The ambiguity effect is a cognitive bias where decision making is affected by a lack of information, or “ambiguity”. The effect implies that people tend to select options for which the probability of a favorable outcome is known, over an option for which the probability of a favorable outcome is unknown. The effect was first described by Daniel Ellsberg in 1961.
In short, we tend to prefer the known to the unknown. This bias can lead to very unfavorable results. Let me give a simple example.
One major unknown in life is how long we are going to live. While we feel our probability of being around in the next year is high, uncertainty around whether we will be around 30 years from now biases us to live for the moment.
From a purely rational point of view, people would be wise to enjoy themselves to a moderate degree now, and to also prepare for the future. Regardless, in a recent EBRI research survey, “about 56% of workers report having less than $25,000 in savings and investments (not including the value of their primary home and benefit plans) and 29% of workers have less than $1,000 saved.”
“People are increasingly recognizing the level of savings realistically needed for a comfortable retirement,” said Jack VanDerhei, EBRI research director and co-author of the report. “We know from previous surveys that far too many people had false confidence in the past.”
So how do we overcome this bias?
One way is to map out the potential futures using scenario analysis. Scenario analysis is a process for defining key axis' of uncertainty, and then defining a set of possible futures or “scenarios” to be considered. The construction of these possible futures encourages us to research and estimate the probability of different scenarios, and then to incorporate these probabilities back into the strategic decisions that we are making.
While this process will not eliminate ambiguity bias, it will reduce it.
In the context of the example we started with, this is exactly what individuals do who are prepared for retirement. They unconsciously paint a set of possible futures, and then take actions today based on the probability that they will be around at 65. The mental process of thinking through what it will be like to retire with insufficient funds overcomes the bias towards living in the moment.
Our next decision error post will be on bias correction! (thinking that you understand Decision Errors and then over compensating for the bias)
If you are interested in getting help in developing research lead scenarios for your possible futures, please contact us to discuss further.