Ingrained cognitive biases that influence decision making.
Business failure is usually a distressing and emotional time for its principals. Many of whom, drowning in debt and facing the prospect of losing everything, grasp for anything that resembles a life preserver. Some grasp at things once inconceivable to them. The question of how they get into those situations has a somewhat ingrained answer.
Two extreme cases I’ve seen is company directors engaging in cheque kiting and debt factoring fraud in desperation to find working capital to continue trading. Until that point, to the best of my knowledge, they had no history of white-collar crime and didn’t profit personally from their actions. Fortunately, the cases of fraud are few and far between. However, more common are high-risk and hazardous decisions and actions which, while effective in prolonging a failed business’s life, usually serve only to delay the inevitable and compound creditors’ losses and other stakeholders in the process. Examples include:
- Misrepresenting the business’s financial predicament to employees, bankers and other creditors.
- Leveraging personal assets or borrowing from family and friends to fund working capital.
- Engaging in unlawful phoenix activity.
This article delves into two related and ingrained factors (not exclusive to financial problems/business failure) that make people particularly vulnerable to making “suboptimal”, and even irrational, business decisions. Those factors are:
- Chronic stress.
- Cognitive bias.
In my experience, financial stress and chronic psychological stress are intrinsically linked. Relationship, health and other personal issues, which can be significant stressors on their own, are frequent companions to financial stress.
Not only does chronic stress have a significant impact on a person’s physical wellbeing, it also impairs cognitive functioning and adversely influences decision-making. In this state, the ability to concentrate can be reduced, thereby creating a bias in favour of high-risk choices and trigger premature conclusions through binary choice-making. Impeding the capacity for critical thinking can naturally lead to suboptimal outcomes for a distressed business. In my opinion, the negative impact of chronic stress on the quality of decision-making may also make decision-makers more susceptible to the adverse effects of cognitive biases.
Studies in behavioural economics gives us insight into how heuristics (i.e. rules of thumb) and cognitive biases influence people’s economic decisions. Two better known examples are:
- confirmation bias—favouring information that matches existing beliefs or biases.
- sunk cost fallacy—continuing a behaviour/endeavour that they’ve previously invested time/money/effort.
Quite often these biases lead to poor decisions and bad judgements—disastrous for financially distressed businesses with already wafer-thin error margins. Although there’s no foolproof way to completely negate the effects of cognitive biases, a lot can be gained from understanding their impact on decision-making—both for our client’s and for ourselves.
In my opinion, which I must concede is not that of an expert of the legitimate or even armchair variety, the combination of chronic stress and cognitive biases provides at least one plausible explanation for why principals of small to medium-sized businesses could make poor decisions when confronting financial stress and possible business failure. While recognising they’re otherwise successful business people who are highly skilled in their trade or profession! Eliminating cognitive biases is an unrealistic goal, however reducing the mental health impact of a financial crisis, including chronic stress, there will always be an important role for insolvency professionals, including accountants, lawyers and other advisors, by providing clarity for our clients and guiding them independent of bias to make more timely, informed and proactive decisions.
We understand the great stress people are under during all manner of financial challenges. If you or your clients require any insolvency advice, please contact your local Worrells office for help.