Risk and Cognitive Bias

Key Takeaways

• Leaders often make decisions when the outcomes may be uncertain.
• A refusal to accept losses can lead to an increased tolerance for risk.
• For firms and countries, leaders with an appetite for risk can lead to disaster.

A certain amount of risk in decision-making is inevitable. We often cannot know exactly how our decisions or actions will play out. However, leaders should be careful about their own biases, especially when it comes to risk. Our risk/reward calculations are not necessarily driven by rationality, and those biases can lead to bad decisions.

In their groundbreaking work on risk and decision-making, Khaneman and Tverskey (1979) developed prospect theory. They found that people have a strong loss aversion that leads to a reflection effect when it comes to our tolerance for risk. Our negative reactions to losses tend to be larger than our positive reactions to gains. As a result, people will often double-down and even engage in increasingly risky behavior to try to recoup a loss, rather than just accept it.

For example, imagine you are in a casino and lose $100 on a spin of the roulette wheel. The rational thing to do would be to walk away since your odds of making that money back are terrible. However, to do so would be to admit that you lost: the money is gone, and you are a loser. Our aversion to that feeling of loss increases our appetite for risk, so rather than walk away people may tend to put more money down on the slim chance that they can recover.

That is a simple example, but in the real world our definitions of “gain” and “loss” are not just based on objective circumstances, but on our perception of where we stand relative to others. Economists and political psychologists refer to this as the aspiration window. In her work on criminal behavior and gender attitudes Cecilia Mo found that wealth inequality, not poverty, was the key determinant of individuals’ risk tolerance. People aren’t more likely to take risks when they are poor, but when they perceive themselves as falling behind because others have more.

In business, this means owners might be more willing to take risks (e.g. increased debt) even when they are making money if they perceive that other businesses are expanding faster. That appetite for risk can lead to unwise investing and instability. Risks can pay off, of course, but may also lead to the destruction of a smaller, but profitable business.

For politicians, an increased appetite for risk can have even more serious consequences. Parties that see lost votes in elections may be more likely to seek new policy positions. Leaders facing potential losses may be more willing to implement risky policy reforms. Views of gain and loss can affect a nation’s decision to use military force. And a refusal to accept a loss may lead to continuing a disastrous military policy.

Indeed, as I write this Russian military forces are massing at the borders of Ukraine, threatening that country with invasion and risking a wider conflict with NATO. It is entirely possible that the U.S. and its allies will be drawn into a conflict. War, in general, is almost always a net loss for a nation, and an attempted invasion and occupation of Ukraine would, even without western intervention, be long, bloody and costly for Russia. But the perception of lost influence in its border region could drive Russia to take a risk rather than accept a lower position in the international order.

Making good decisions means understanding your own cognitive biases. Be aware that gains and losses can be relative and avoid the impulse that comes when you perceive yourself falling behind. Risk can be managed and incorporated into decision-making. But risks should be taken based on the objective value of the action, not on the perceived value and need to satisfy a cognitive bias.