THE ROLE OF COGNITIVE BIASES
If there’s a single psychological concept that every aspiring entrepreneur should understand, it’s the phenomenon of cognitive biases. Cognitive biases are mental and emotional filters that help us make sense of the constant barrage of information coming at us every minute of every day. They determine how we frame our interactions with the world, where we focus our attention, what patterns we select, what data we see as important versus irrelevant, and how we reach conclusions. Like software programs running quietly in the background of our mental computer, these biases operate continually and reflexively. As with blinking and swallowing, they are always at work but rarely noticed.
For the most part, cognitive biases are tremendously helpful, allowing us to make quick judgments and navigate through an increasingly information-rich world. It would be impossible to get through our day without them. But they also play a central role in perpetuating the passion trap, leading to errors in reasoning and the recycling of flawed assumptions and choices. In one sense, launching a business is nothing more than a rapid series of decisions, one after the other, and startup founders must continually improve their ability to recognize patterns, analyze these patterns efficiently, then make the right calls, all at a rapid-fire pace. In growing D1 from a blank sheet of paper into a successful national competitor, J. C. Faulkner didn’t think of his business as being about mortgages. Instead, he focused on making quick, high-quality decisions and on building a team and a culture that could do the same. “That’s the core business we were in,” he says. “Making great decisions efficiently.”
In the startup environment, the importance of making good decisions is complicated by the naturally high levels of passion and emotion associated with launching a big idea. As we saw in Chapter One, the mechanisms that reinforce our beliefs operate at a neurological level, where thoughts and emotions are tightly intertwined. No choice is made at a purely intellectual level. In fact, a good deal of research in cognitive psychology and neuroscience suggests that emotions drive our decision making processes, even when we are completely unaware of their role.9
Of the many biases that sabotage our startup reasoning, here are a few that every startup founder should understand, as they are especially likely to trip up entrepreneurs who are passionate about their idea:
■ Confirmation Bias—our tendency to select and interpret available information in a way that confirms our pre-existing hopes and beliefs. Lynn Ivey, for example, heard a lot of positive feedback about her idea for a high-end adult daycare center, but she can also recall some notable dissenters: a former healthcare system CEO, who thought in-home care services would be a formidable competitive force; a board member, who was concerned that customers wouldn’t pay such high fees; and an expert on services for the aging, who felt a for-profit center would never work. These views were easily dismissed and drowned out by supporters, whose opinions paralleled her own. In retrospect, the dissenting views form a pattern of concern. But at the time, they were just isolated exceptions to a clear majority.
■ Representativeness (belief in the law of small numbers)—the tendency for entrepreneurs to reach conclusions based on a
Small number of observations or a few pieces of data. Entrepreneurship researchers have concluded that startup founders often fall victim to this bias, because they operate in uncertain and fast-moving environments where facts can be hard to obtain.10 The new founder who hears positive reviews from three out of four friends and then assumes that 75 percent of the general population will react similarly is under the spell of representativeness. It’s also in play when a wanna-be entrepreneur reads a magazine’s worth of success stories and assumes much higher success rates than actually exist across the general population.
■ Overconfidence/Illusion of Control—these are actually distinct cognitive biases, and each has both positive and negative impacts on entrepreneurial success.11 Overconfidence leads founders to treat their assumptions as facts and see less uncertainty and risk than actually exists. Illusion of control causes business owners to overrate their abilities and skills in controlling future events and outcomes. Both of these tendencies drive entrepreneurs to develop rose-colored plans and fail to prepare for inevitable bumps in the road. One study of startup ventures across a range of industries, for instance, found that more than 80 percent failed to meet confidently established market share targets.12
■ Anchoring—our mind’s tendency to give excessive weight to the first information we receive about a topic or the first idea we think of. This bias is all about the stickiness of first ideas and impressions. It encourages founders to cling to an original idea or, if pressed, to consider only slight deviations from the idea instead of more radical alternatives. An example of anchoring is the role it plays after initial sales or cost targets are set by a founding team. Even if the forecasts are wildly optimistic (as they often are), they continue to serve as anchors for future planning processes, influencing forecasts toward unrealistic levels.
■ Escalation of Commitment (“sunk cost” fallacy)—the tendency to continue or increase commitment to an endeavor based on prior investment of money, time, and energy. Startup founders may refuse to abandon a losing strategy in an attempt to preserve whatever value has been created up to that point. Paul Graham, accomplished entrepreneur (Viaweb) and investor (Y Combinator), refers to this phenomenon as the “still life effect,” based on his experience as a painter. He noticed his tendency to continue painting a poorly arranged composition (a bunch of stuff “plonked” on a table) simply because of the time already invested in the project. This parallels a common approach among startup teams. “You come up with a random idea, plunge into it, and then at each point (a day, a week, a month) feel you’ve put so much time into it that this must be the idea. . . Plunging into an idea is a good thing. The solution is at the other end: to realize that having invested time in something doesn’t make it good.”13