A formal decision-making process can also prevent your company from being guided by fallacy – often the result of gut decisions or a lack of planning. In the field of behavioral decision theory, which examines the separation of objectively rational decision-making and (often irrational) intuitive decision-making, these fallacies fall into the latter category.
“Decision-making fallacies are rampant in companies of all sizes,” Stephens said. One example of this is sunk cost bias, in which irretrievable investments are used to justify future decisions, only to cause further harm (think of the U.S.’s unwillingness to withdraw from the Vietnam war).
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Stephens gave the example of a client who was selling their business to cover the debt and investment they had put into it. They were selling it based on expected performance rather than actual market value. The price was too high, and no one was willing to buy. “I pointed out that those numbers were sunk costs that were irrelevant to both them and the buyers,” he said.
Another example is extrapolation bias, in which current trends – such as a rise in housing prices – are expected to continue in the same direction, a fallacy that Stephens often observes in finance.
The field of behavioral economics is rife with examples of how common misconceptions lead to enormous financial loss – Stephens outlined several more in this blog post.