Magazine article The RMA Journal

Don't Kid Yourself, You're Biased: Stay on Guard against the Cognitive Biases That Can Affect Us All

Magazine article The RMA Journal

Don't Kid Yourself, You're Biased: Stay on Guard against the Cognitive Biases That Can Affect Us All

Article excerpt

HAVE YOU EVER wondered why highly intelligent, well intentioned, and competent people end up making bad decisions? How is it that JPMorgan Chase, with one of the best management teams in financial services, suffered a huge and embarrassing "London Whale" trading loss in 2012? Indeed, how could so many of us--bankers, regulators, rating agencies, and investors--have missed signs of the 2007-09 financial crisis?

The answers would be easy if we were dumb, incompetent, crooked, lazy, and self-serving. And that may be part of it. But the whole story is a lot more complicated. Because of the way our brains are wired, we often reach conclusions that are wrong, yet we are very confident of those same conclusions. This article will explore why we so often get it wrong and why this is relevant to risk management. We should declare now that there are no easy or magical solutions.

Risk management is about answering three very basic questions:

1. Should we do it? (Aligned with strategy, risk appetite, culture, values, and ethics.)

2. Can we do it? (People, processes, structure, and technology capabilities.)

3. Did we do it? (Assessment of expected results, continuous learning, and a robust system of checks and balances.)

But answering these questions well and reaching a good decision are very difficult, especially when:

* Information is flawed.

* Information is not shared.

* Information is simply not available.

* Information is misunderstood, manipulated, ignored, or misused due to cognitive biases.

If your job is to make sure the best decision is being made, you need to understand what cognitive biases are and how they influence decision making. They are only part of the reason why it is often difficult to make good decisions, but they are a significant part. Most importantly, they can be part of why employees act in ways that are inconsistent with the best interests of their employers or their employers' customers. Such acts can be dishonest or even illegal.

Given the financial penalties the law can impose and the reputational penalties that may be inflicted by customers, employees, investors, and others, minimizing the cognitive bias that can foster ethical and legal wrongdoing is an extremely important aspect of risk management.

So what is a cognitive bias? It is a pattern of deviation in judgment leading to perceptual distortion, inaccurate judgment, illogical interpretation, or what is broadly called irrationality. In a recent check of Wikipedia, the list of cognitive biases topped 120. In this article we have room to explore only three: authority, conformity, and groupthink.

Authority Bias

People have evolved such that they are inclined to please authority Children strive to please their parents, their teachers, and the police officer down the block. Even in adult brains, the pleasure centers light up when people please their superiors. Obedience to authority is a natural human tendency Unfortunately, people often go too far.

Firms need employees to act ethically and legally But in attempting to please authority figures, subordinates may fail to exercise independent ethical judgment. Laboratory experiments and empirical studies make it clear that people are more likely to violate ethical and legal rules when instructed to do so by superiors, when they are simply urged to do so by superiors, and even when they merely believe it will please superiors.

Sometimes excessive deference to authority is a conscious, cowardly decision. Thus, Henry Blodget and other sell-side stock analysts of the dot-com era recommended stocks that their superiors wanted them to showcase, even though they knew the stocks were frequently "dogs" and worse. Their private e-mails expressed an inability to muster the courage to act honestly.

But it is probably just as often the case, and more worrisome, that a subordinate can become so intent on pleasing the boss that the ethical issue may barely register or just fade into the background. …

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