You have just been retained as a strategic consultant to help a 100-year-old fir

Question

You have just been retained as a strategic consultant to help a 100-year-old firm evaluate its capital budget decision making. Your first look at the firm’s prior decision making appears to indicate that management has oftentimes used an approach fraught with repeated biases and heuristics. Your task is to present an introductory session that highlights the inherent risks of adding psychology to finance (i.e., behavioral finance). Outline five common biases or heuristics that may negatively impact profit maximizing capital budgeting decision making and give an example of how each one may lead to a suboptimal decision.

Explanation / Answer

Five common biases that may negatively impact profit maximizing capital budgeting decision making are discussed below:

(i) Anchoring bias – This bias leads the decision makers to focus only on a single piece of information with regards to estimation of unknown values. For example when decision makers are facing large anchors with regards to the price of the project or investment they may not be able to properly assess costs.

(ii) Loss aversion and status quo bias – This biases lead the decision making individuals to react to gains and losses on a relative basis and based on a particular reference point. For example when a particular project or investment is making losses the decision makers instead of closing the project and investing in a new capital project increase investments in the loss making project.

(iii) Availability bias – This bias leads the decision makers to make use of those examples that are easily available to determine the outcomes of difficult problems. For example in capital budgeting availability bias may lead to support for large investment projects to fall beyond the rational parameter. This will influence the likelihood of the project getting approved.

(iv) Familiarity bias – This bias leads the decision makers to believe in things that they are familiar with while making capital budgeting decisions. For example in capital budgeting decision makers will often invest in projects that they are familiar with.

(v) Conformation bias – This bias leads the decision makers to interpret the information in a manner that will confirm their preconceptions and pre-conceived notions. For example in capital budgeting decision makers will recall information selectively use the recalled information to determine the investment decisions in different projects.

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