As a problem solver, which everyone is one way or another, it is of great importance to acting in a rational way at all times. A rational thinker uses philosophy, logic, and deduction to draw insights from the problem at hand. In consulting roles, this particular trait is almost non-negotiable, as the solutions provided will be used by clients to make important life and business decisions. However, how reliable is the advice being provided by consultants? How certain can clients be that the advice they receive has not been affected by external factors provided by consultants as the solutions you provide your clients will? The actions emanating from this advice can have fairly far-reaching effects, some affecting entire stock markets, and economies. Many studies have shown that stock price movements can sometimes not be fully explained by known theories, i.e. they do not move in a rational way. In a paper titled “Evidence that stock prices do not fully reflect the implications of current earnings for future earnings”, V.L. Bernard and J.K. Thomas initially believed that this was evidence of inadequacies of existing theories, as stock prices of some small to medium-sized firms would take more than half a year to fully react to earnings news. However, C. Lee, A. Shleifer, and R. Thaler then revealed that stock markets can be affected by investors’ sentiments, which are not always rational. Their conclusions are in line with results from work done by R.J. Shiller on excessive volatility, which showed that stock price movements cannot be explained by new dividends information. So how are decision-makers influenced to make them so irrational?
Concepts from behavioural finance attempts to explain this. A common one is anchoring. Anchoring occurs when one is exposed to certain information which then serves as a reference for future decisions. An example of anchoring is when asked to estimate the price of an object given the price of another object. Even if the objects are not similar or linked, people tend to use the price given as a reference for the estimated price.
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Another common concept is prospect theory, which attempts to explain how individuals make decisions in light of uncertainty. Depending on whether a person’s attitude towards risk, a promotion that presents an equal chance to either win or loses a large amount can be viewed by the risk seeker as an opportunity to win that large amount, whilst the risk-averse person would view it as a risk to lose the amount. This concept is the development of a concept called framing. The concept of framing suggests that the way a gamble is framed affects the interpretation and thus the decisions that follow. For example, a project presented to the senior managers and decision-makers framed with a 75% chance of success, could have a different response to one framed as having a 25% chance of failure.
A study by Kahneman and Tsversky’s paper on “Choices, values, and frames” asked the question, why individuals would rather spend $10 on a theatre ticket after losing a $10 bill than to replace a lost ticket worth $10. This question is answered by the concept of mental accounting. Mental accounting states that way people deal with money depends on the intended use and where the money came from and ignores the overall effect on one’s account. In the question asked by Kahneman and Tsversky, in both instances, $10 had been written off and another $10 had been used to buy the ticket, however, the instances are likely to not be treated the same.
The quantity and ordering of choices can also affect the decisions made. The recency effect states that people are likely to choose the most recent option offered especially if the decision is made close to a deadline, whilst the primary effect explains that people tend to prefer the first choice. Other decisions are made on a status quo bias basis, in which they prefer things to remain the same. Overchoice, then states that when presented with too many choices, many people can become unhappy, or feel drained, and in many cases, fail to decide due to the overload of choices.
These are just a few examples of how irrational we can be in the decision-making process. It would be good practise to incorporate the use of analytics to ensure that decisions made are at least evidence-based.
Nyasha Mukechi is a Consultant at Industrial Psychology Consultants (Pvt.) Ltd a management and human resources consulting firm.
Phone +263 4 481946-48/481950 or cell number +263 773274381 or email: nyasham@ipcconsultants.com or visit our website at www.ipcconsultants.com