Editorials

We encourage our readers to submit relevant articles of interest to be published on this web site. Students, members, and companies are invited to take advantage of this opportunity! Please send your editorial to: Dick Forrest, CPIM dforrest@charter.net

Ira Smolowitz, Ph.D. Professor of Finance and Dean, Bureau of Business Research and Program Development at the American International College, Springfield, MA.

Some of Ira's past articles of interest:

• A View of Education From Both Sides: An Assessment of the American Education System
• Ramifications of the 24/7 Economy
• Work-place Gossip: A Reassessment
• The Disappearance of Courtesy in America: Implications for Business
• The Outlook for American Competitiveness
• Consumer Marketing: A Flawed Strategy
• A Healthy Workforce: The Driver of Corporate Financial Performance
• The Use and Misuse of Forecasts
• Decline in Ethics: Decline in National Competitiveness
• Promoting Prudent Corporate Growth
• The Dynamic of Successful Marketing
• The Monty Hall Paradox: Lessons for Management
• Improving American Competitiveness
• Get to the Root Cause of Factory Failure: Ask the Five Ways
• The Halo Effect: Proceed with Caution
• Improving American Competitiveness
• The Conflict Between Symbolism and Substance
• Virtual Teams: Identifying The Benefits and Problems
• Assessing Potential Management Talent

Identifying and Avoiding a Common Decision Trap

By Ira Smolowitz, Ph.D.

For the typical supermarket shopper a reduction in the price of an item from $3.94 to $3.93 has virtually no impact. However, a penny reduction from $2.00 to $1.99 has a disproportionate impact. The typical consumer focuses disproportionately on the first digit of the new price vs. the first digit of the old price. As a consequence, the penny reduction from $2.00 to $1.99 will trigger a favorable reaction from the consumer. Psychologists call this decision behavior – anchoring.

Consider the following anchoring trap. “The average home business has a 75% chance of success. What do you estimate as your chance of success? What if I had told you the average home business has a 25% chance of success? Does your estimate change?” ¹

The pioneering work in behavioral finance was conducted by the Nobel Laureates Daniel Kahneman and Amos Tversky. Kahneman and Tversky contended that people frequently form estimates by starting with a given, easily available reference value – which could be arbitrary – and adjusting from that value. An estimate, therefore, would be “anchored” to that value. (Think of auto salespeople starting negotiations at the manufacturer’s suggested retail price.)

To demonstrate this heuristic, Dan Ariely, professor of management science at MIT Sloan School of Management, conducted a mock auction with his MBA students. He asked students to write down the last two digits of their Social Security numbers, and then submit bids on such item as bottles of wine and chocolate. The half of the group with higher two-digit numbers bid “between 60 percent and 120 percent more” on the items, says Ariely. ²

Here is another example of the anchoring trap as demonstrated by Hammond, Keeney and Raiffa:

How would you answer these two questions?

Is the population of Turkey greater than 35 million?

What’s your best estimate of Turkey’s population?

If you’re like most people, the figure of 35 million cited in the first question (a figure we chose arbitrarily) influenced your answer to the second question. Over the years, we’ve posed those questions to many groups of people. In half the cases, we used 35 million in the first question; in the other half, we used 100 million. Without fail, the answers to the second question increase by many millions when the larger figure is used in the first question. This simple test illustrates the common and often pernicious mental phenomenon known as anchoring.

When considering a decision, the mind gives disproportionate weight to the first information it receives. Initial impressions, estimates, or data anchor subsequent thoughts and judgments. Anchors take many guises. They can be as simple and seemingly innocuous as a comment offered by a colleague or a statistic appearing in the morning newspaper. They can be as insidious as a stereotype about a person’s skin color, accent, or dress. In business, one of the most common types of anchors is a past event or trend. A marketer attempting to project the sales of a product for the coming year often begins by looking at the sales volumes for past years. The old numbers become anchors, which the forecaster then adjusts based on other factors. This approach, while it may lead to a reasonably accurate estimate, tends to give too much weight to past events and not enough weight to other factors. In situations characterized by rapid changes in the marketplace, historical anchors can lead to poor forecasts and, in turn, misguided choices. ³

The authors of the above article indicate that to avoid the anchoring trap, the decision maker should: “pursue other lines of thought in addition to your first one.” “Seek information from a variety of people and sources after thinking through the problem on your own.⁴

In the fast-paced, 24/7 work-place, anchoring, it seems to me, will become a more pervasive problem. It is a problem that decision makers must vigilantly strive to avoid. To conclude with a pun – in nautical terms it’s ‘anchors aweigh’, in decision making it’s ‘anchors away’.

References

1. Merriman, K.K. “Better Business Through Better Judgment” Home Business Journal published January 05, 2006 – downloaded 5/3/2006 from www.homebizjour.com/articles p. 1.

2. Teach, Edward “Avoiding Decision Traps” CFO Magazine, June 01, 2004 – downloaded
5/4/2006 from www.cfo.com/printable/article.cfm p. 1.

3. Hammond, John S., Keeney, Ralph L. and Raifa, Howard “The Hidden Traps In Decision Making” Harvard Business Review, January 2006, p. 120.

4. Downloaded from Harvard Business Review, On Point, May, 2006, p.

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Articles printed with the permission of Dr. Ira Smolowitz, Professor of Finance and Dean, Bureau of Business Research and Program Development at American International College, Springfield, MA.