How Human biases affect Business decisions

Everyday Human biases affect business and economic decisions. In developed economies, people are now regarded as being highly educated, globally connected and socially free, yet they still managed to create a historic economic crisis which dramatically affected all of our lives over the last ten years. There is a school of thought that this crisis arose because heuristics and biases influence the human decision-making process.

I am going to explore our recent economic past to show how five of these Human biases affect business behaviours and will play a part in our future.

1. Hyperbolic Discounting

“Hyperbolic Discounting refers to the behaviour of people procrastinating and leaving things to the future”.

This was a feature during Ireland’s property crash when many homeowners facing negative equity, arrears, and possibly the loss of their homes refused to engage proactively with their lenders (as well as advice providers and, if necessary, the courts) so that solutions could be found to resolve their issues. Eventually, having suffered stress and other hardships because of this behaviour, they ended up, by choice or by force, engaging with their lenders and resolving their financial situations.

Another consequence of the financial crisis is the pension time bomb. Many people are not putting money aside for a pension. People may be burdened with high property debts, while others might be focused on saving money to buy a house. The age for a government pension is rising, and the reality is that, by 2028, Ireland will have one of the highest pension ages. The OECD, in its 2017 report, highlighted that governments are trying to address this issue through several options such as Flexible retirement schemes or mandatory state pension contributions.

But the last ten years have also shown that governments can also be affected by procrastination. An example of this is the Greek Crisis. For many years Greek governments gained political power based on how much they would give to their citizens irrespective of the financial consequences. A straightforward way to highlight this approach was Greece’s national railroad which had annual revenues of €100 million yet had an annual wage bill of €400 million. Many Greek governments also never tackled the countries culture of tax evasion. Instead, consecutive Greek governments borrowed lots of money without any plans on how to repay that money back. When the Financial Crisis affected Europe, Greece, due to its history of procrastination, became the hardest hit of all the countries within the Euro area.

This behaviour has been a massive cause in our failure to tackle the climate crisis. The climate crisis will have a major economic impact. People and their governments are finally coming around to address the issue of global warming. However, it is being driven by children such as Greta Thunberg who possibly may suffer less from the influence of hyperbolic discounting.

2. Bandwagon effect

“The bandwagon effect is a psychological phenomenon in which people do something primarily because other people are doing it, regardless of their own beliefs, which they may ignore or override”.

A famous economic example of this behaviour is the dot com bubble of the late 1990s. Here “.com” start-up companies with no products and no business plans were able to attract millions of dollars from investors in large part due to the bandwagon effect.

Many European banks were affected by the bandwagon effect. In Ireland, our banks legacy with tracker mortgages is one such example. David McWilliams (2009) says that before 2001, there was no such thing as a tracker mortgage in Ireland. However, in 2001, RBS introduced tracker mortgages into the Irish market. All other banks followed suit and this cumulated in 2007 with 74% of the mortgages issued that year being tracker mortgages. The problem with tracker mortgages is that they do not make the banks any money. All that they were designed to do was to lure in customers. The banks hoped that they could make some real money through selling these customers other financial products.

German banks also lost severe amounts of money because of this phenomenon. Michael Lewis (2011) mentions that the German story is quite a unique story in terms of the financial crash. During the times of easy credit, German bankers became frustrated by the lack of interest in their domestic market for credit. So one German bank called IKB invested heavily in US subprime mortgage bonds through its conduit called Rhineland funding. It appeared to be a great model to earn money, so lots of other German banks jumped on this bandwagon, copied IKBs model and invested in US subprime mortgage bonds. When the crash came IKB needed to be bailed out, but many other German banks such as Deutsche Bank, Landesbank Bayern and Dresdner Bank lost billions of euros because they followed the IKB approach to lending in the US.

3. Representativeness Heuristic

“Representativeness Heuristic is a cognitive bias in which an individual categorizes a situation based on a pattern of previous experiences or beliefs”.

The “Big Three” global credit rating agencies—Standard and Poor’s (S&P), Moody’s, and Fitch Ratings—came under intense examination in the wake of the global financial crisis. A Council on Foreign Relations (2015) report states that the function of these credit agencies was to provide investors with reliable information on the riskiness of various kinds of debt. However, these agencies have been accused of exacerbating the financial crisis and defrauding investors by offering overly favourable evaluations of insolvent financial institutions and approving extremely risky mortgage-related securities. They failed partially because of their heuristic approach in following each other and also believing that the entire banking system was sound because all the banks were doing the same thing.

After the subprime crisis, when dealing in Europe, the credit agencies went the opposite direction over their sovereign debt ratings. While the public debt of crisis-hit countries like Greece, Portugal, and Ireland was relegated to “junk” status, the agencies also downgraded, due to this heuristic, the creditworthiness of France, Austria, and other major Eurozone economies. EU officials have argued that these moves accelerated the Eurozone’s sovereign debt crisis.

Another possible example of this heuristic was the involvement of the then European Central Bank President Jean-Claude Trichet in preventing, this view is challenged by Trichet, the Irish Finance Minister Michael Noonan from burning the bondholders. Perhaps Trichet was aware that heuristic bias exists within the financial system and this could possibly have had knock-on effects on other countries within the EU if Ireland decided to burn the bondholders so, it is claimed, that he intervened and prevented Ireland from burning its bondholders.

4. Confirmation Bias

“Confirmation bias occurs when people seek out or evaluate information in a way that fits with their current thinking and preconceptions.” (The behavioural economics guide 2015).

There was a belief within the banking community that the government would bail them out if they got into trouble because they were “too big to fail”. So they felt that this allowed them to increase their financial exposure and take on additional risks. This perception burst when the US government refused to bail out Lehman Brothers who at the time were the fourth biggest investment bank with over 25,000 employees. This action sent shock waves through global finance and caused every financial institution to look at the financial assets it was holding and also to wonder if the protection insurance policies which they owned would be capable of being redeemed.

This bias also affected ordinary people as they then thought that the banks were going to run out of money. So many people began to withdraw their deposits from the banks even though there was no need. These actions led to a run on the banks across Europe and forced governments such as the British Government to nationalise the banking industry.

History shows that during times of economic distress, people’s biases surface as they try to determine the causes of their economic duress. In the 1930s, the Nazi’s incorrectly blaming the Jews for their financial issues. Today in the USA, Donald Trump blames immigrants, while in the UK, the European Union is blamed for its economic difficulties.

5. Anchoring – Human Biases affect Business

“Anchoring is a particular form of priming effect whereby initial exposure to a number serves as a reference point and influences subsequent judgments about value. The process usually occurs without our awareness.” (Tversky & Kahneman, 1974).

Ireland’s property boom was, in part, fuelled by this bias. People became fixated on the prices of property and not the cost of it. Websites and property pages influenced this bias. All that they could see was the constant rise in values. During this time, many people believed that property prices only went up and never down. This proved to be very wrong when the prices dropped during the property crash.

The actions of the many banks also enforced people’s biases regarding the property. Banks were actively encouraging people to borrow money for a property because the prices were always going up. The banks hired sales teams to sell loans. Some banks offered customers 100% mortgages or interest-only mortgages. People felt that if the banks are offering this, then, the perception of continuing rises in property prices was validated.

Today we still see the legacy of this bias as people are living in homes classed as “negative equity”. This bias has ripped apart Irish society. Today, its people are unable to move out of homes which are unsuitable for them.

Conclusion – Human Biases affect Business

There is a famous saying that “History has a funny way of repeating itself”. As long as humans are involved in business and economics, heuristics and biases will always influence it. Possibly the saying “to err is human” could be an excellent way of describing our historical past and our pending future.

About the Author – Human biases affect business

Aidan Conaty is the founder of TCI China and Goodada.com. Aidan has spent over 15 years assisting companies to trade internationally. TCI China provides trade support services for China. Goodada helps companies to trade internationally. He is a recipient of the Seamus Ennis MBA scholarship at Trinity College Dublin.

Aidan can be contacted email at aidan@goodada.com or at:

(Europe/ Rest of the World) +353 1 885 3919
(UK) +44.020.3287.2990
(North America) +1.518.290.6604

References

David McWilliams (2012) – The Good Room – Penguin Books – pages 9 & 10

Michael Lewis (2011) – Boomerang – Penguin Books – chapter 4, 133-170

Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science (New Series), 185, 1124-1131.

Alain Samson (2015) – The behavioural economics guide 2015 – page 30

Behavioural Insights Team (2018) – Testing behaviourally-informed messaging to increase rates of contact between mortgage lenders and customers facing arrears.

OECD (5^th December 2017) – Pensions at a Glance 2017