An important aspect that has been ignored is the requirement of adding necessary input when making any decision. But if you take a closer look, you will find that estimates of capital costs and cash flow are basically taken as per the judgment of an individual. As humans are prone to making mistakes or said with a better terminology, committing systematic decision errors, calculations on a manual level may cause mistakes at a higher level. So, those managers who fail to identify such biases have tendencies of making too many mistakes and take incorrect decisions.
There are more than a dozen errors related to behavioral issues. However, in this chapter, we will be discussing the prominent 3. These are:
- Overconfidence
- Relativism
- Compartmentalization
Highlighting all these 3, its description will be:
Overconfidence
This is the first in the list which related the tendencies of individuals to think better of their projects that the others. In fact, they think that evaluations made by them are more precise and attaining that level is not possible by anyone else. On an experimental basis, a certain number of people were asked to give a confidence interval of 90%. In this, only the confidence level of these people is analyzed. Where out of 10, 9 begin with higher confidence level; but the end of the time only 5 proves to be true to their statement.
Now if you think to record the overconfidence of these people, this is not possible. Where in firms, managers already know of their shortcomings, no one from those group will agree to write or record their confidence level. What they apply is not letting their companies know about it and the shaky condition which these firms may face. From this, we can relate the fact that those people who are overestimating, optimistic approach towards their life can become entrepreneurs.
Relativism
In this case, an individual’s tendencies are to consider relative scale and its problems which in reality they should not. If you take a closer look, you will find people utilizing 20 minutes extra and buy groceries worth $80 so that they can save $40. But they are not willing to drive the same 20 minutes to buy a new car worth $20, 000 by burning the fuel worth $100. When it comes to buying a car, percentage context, in this case, is 0.5%, whereas it is 50% for buying grocery.
This can be stated as a flawed concept. Comparisons of it are made with projects or IRRs where the scales are not considered. In both the cases, timings are exact. However, people look the amount- $100 and $40. So when percentage calculation is made, they don’t see the lesser amount at stake. What they are unaware is the gravity of the issue ha may arise in this case.
Another example can be given for a gas station where the advertised price for gas is given to be $1. Now, in another gas stations, gas values are put at $1.2. Even if the $1 gas station is far, people are ready to travel miles and even stand in a queue to save that $0.2.
Compartmentalization
Here the tendency of people is to take or make decisions as per category. You can find instances when it comes to putting in more amount in a specific category when the windfall is unexpected.
If you go for a soccer match and also play lottery; and win it, there are high chances of you to think that to be a sign of good luck. As a result, when you go to see another of a soccer match, it’s likely for you to buy another lottery ticket.
ANECDOTE
Small Business Failures
Within a year in New York, out of 5 restaurants,2 close down. So on a national level, the estimated percentage is 90% for the duration of 2 years. Turnover percentage of an averagely successful restaurant will be 10%. Still after seeing this percentage entrepreneurs do open their restaurant. This is mainly because of their over-optimistic approach. As per the study of Small Business Administration, 33% as failure percentage can be seen between 1989 and 1992. In this case, the lasting period of most restaurants was 2 years.
Percentage of failure for 4 years was 50%, and for 6 years it was 66%. Again another survey was made taking 3000 entrepreneurs where the estimation of not facing a failure was 33% and facing 70% failure was 81%.
Links of Previous Main Topic:-
- Capital budgeting applications and pitfalls
- Promised expected typical or most likely
- Badly blended costs of capital
- The economics of project interactions
- Evaluating projects incrementally
- Real options
Links of Next Financial Accounting Topics:-
