Most cash flow and cost-of-capital estimates rely on judgments. Unfortunately, it is often difficult to obtain accurate judgments. Our brains tend to commit systematic decision errors.
Managers who do not recognize these biases will systematically make poor decisions.
There are literally dozens of well-known behavioral errors, but limited space allows us to highlight just three: overconfidence, relativism, and compartmentalization.
1. Overconfidence is the tendency of people to believe that their own assessments are more accurate than they really are. In lab experiments, ordinary people are found to be dramatically overconfident. When asked to provide a 90% confidence interval—which is just a range within which they are confident that their true value will lie in nine out of ten tries—most people end up being correct only five out of ten times.
It is difficult to empirically document overconfidence—after all, if it were easy, managers would recognize it themselves and avoid it. However, we do have evidence that many managers who are already heavily invested in their own company tend to throw caution overboard and voluntarily invest much of their own money into the corporation—and even in companies going bankrupt later on. There is also good empirical evidence that those of us who are most optimistic in overestimating our own life-expectancy disproportionately become entrepreneurs. Even if optimism is a disease, it seems to be a necessary one for entrepreneurs!
To understand this better and to test your own susceptibility to these problems, you can take a self-test at the website, http://www.cashtrailer.com/. Doing so will likely make you remember this problem far more than reading long paragraphs of text in this blog. Incidentally, the only population segments who are known not to be systematically overconfident are weather forecasters and clinically depressed patients.
2. Relativism is the tendency of people to consider issues of relative scale when they should not. For example, most people are willing to drive 15 minutes to a store farther away to save $20 on the purchase of $30 worth of groceries, but they would not be willing to drive the 15 minutes to a car dealer farther away to save $100 on the purchase of a new $20,000 car. The savings appears to be less important in the context of the car purchase than in the context of a grocery purchase. This is flawed logic, similar to comparing IRR’s while ignoring project scale. The marginal cost is driving 15 minutes extra, and the marginal benefit is a higher $100 in the context of the car than the $20 in the context of the groceries. Put differently, the problem is that we tend to think in percentages, and the $20 is a higher percentage of your grocery bill than it is of your car purchase. The smaller the amount of money at stake, the more severe this problem often becomes. When a gas station advertises a price of $2 per gallon rather than $2.10, customers often drive for miles and wait in long lines—all to fill a 20 gallon gas tank at a total savings that amounts to a mere $2.
3. Compartmentalization Compartmentalization is the tendency of people to categorize decisions. Most people are more inclined to spend more when the same category has produced an unexpected windfall earlier. For example, winning a lottery prize while attending a baseball game often makes winners more likely to purchase more baseball tickets, even though the project “baseball game” has not changed in profitability. Similarly, an unexpected loss may stop people from an otherwise profitable investment that they should make. For example, say an individual likes to attend a particular baseball game. If she loses her baseball game ticket, she is less likely to purchase a replacement, even though the cost and benefit of purchasing the ticket are the same as they were when the original ticket was purchased.