Cognitive Biases in Entrepreneurial Strategies

The view of the human as a rational being is nowadays heavily questioned (Simon, 1959), UT in science a lot of models and theories still are based on this assumption. When looking at research on entrepreneurship, we notice that it is considered a relatively new field of study, though practice has shown that entrepreneurial activities have a great influence on the market. Schumacher (1934) already linked entrepreneurial Initiatives of Individuals to the creation and destruction of Industries, as well as to economic development.More research has been conducted about entrepreneurship, which questions the classical picture of the economic man – Homo economics – and he classical concept of rationality. This might be because the entrepreneur himself Is one of the most crucial factors of either the success or failure of an entrepreneurial business. This has caused the entrepreneur to be a hot topic and so a lot of research has been dedicated to the phenomenon. An Shame to (200 0) for example different argues that the underlying factor that causes entrepreneur knowledge. Other research has focused on the traits of entrepreneurs.In general, entrepreneurs are considered overconfident (Cooper et al. , 1988), which is a good thing if you want to start-up a company. Without this trait, start-ups would probably not take place as often as we observe (Goodness & Lecher, 2013). However, research has also showed that this overconfidence is associated with failure (Camera & Lovable, 1999). Nobel (2011) argued that although we know 30 to 40 per cent of entrepreneurial firms fail, many other are bought out or never bring expected return on investment, meaning that the real failure rate can be up to 70 or 80 per cent.Overconfidence is one of the known biases that influence human beings in decision making. There are, however, a lot of more biases which an entrepreneur can encounter. This raises the question of whether being aware example of such of the biases could help the bias, entrepreneur in his activities. If we look at the overconfidence overconfidence can lead to wrong decisions. Awareness thus, could be helpful. On the other hand, if the entrepreneur is aware of this bias he could become too careful in the decision making process. This can result in no action being taken when the ‘moment' arrives.Or it could result in the entrepreneur even deciding not to continue due to the risks being too high. This leads us to the question: 3 The following questions will help us answer the main question by shedding some eight on the biases that are out there: Theory of Bounded Rationality As mentioned in the introduction, we assume Homo economics appears to be perfectly rational and has complete knowledge, while the economic choices one makes are clandestine in the economic sphere without affecting other aspects of the individual such as emotions or being influenced by the environment.This is in line with the neoclassical economic theory that assum es full What is a cognitive bias? Why does this article address cognitive biases? What kind of cognitive biases could an entrepreneur encounter? Theory In this section the previously stated substitutions will be answered based on theory of decision-making, cognitive biases and the application to entrepreneurship. Entrepreneurship We accept the definition of entrepreneurship as suggested by Stevenson and Carillon (1990): ‘Entrepreneurship is about individuals who create opportunities through various modes of organizing, without regard to resources currently controlled. Sevens and Carillon moved away from the view of the traits school' which tried to describe how entrepreneurs differed from other people by control, leadership, or propensity for risk-taking. When studies showed that entrepreneurs are as different from one another as they are from school' non- entrepreneurs, the ‘behavioral rationality. This view has been criticized by Simon (1959) who developed an approach based on bounded rationality and problem solving. Simon stated that the assumption of full rationality is unrealistic.In his view, the rationality of individuals is limited by the information they have, the cognitive limitations of their minds and the finite amount of time they have to make decisions. The theory of bounded rationality states that individuals face uncertainty about the future and costs in acquiring information in the present. What is a cognitive bias? Biases and heuristics (mental shortcuts) are decision rules, cognitive mechanisms, and subjective opinions people use to help them making decisions. This is a deviation of the benchmark Cognitive of biases rational prevent decision-making. Individuals to accurately understand reality and interfere with the ability to be impartial, unprejudiced or objective (Goodness and Lecher, 2013). Taverns and Keenan (1974) state that people rely on ‘heuristic principles which reduce the complex tasks of assessing probabilities and predicting values to simpler Judgmental operations. There are specific and systematic biases that move the Judgment away from the perfect rationality of individuals. Argued that the process of creating a new venture, should be the fundamental part of defining someone as an entrepreneur. (Gideon, 2010).This is why we agree on the definition by Stevenson and Carillon, which also implies we will not discuss entrepreneurial traits in this article. 4 Drawing on aspects of both psychology and economics, the operating assumption of behavioral economics is that cognitive biases often prevent people from making rational decisions, despite their best efforts. Why do we focus on cognitive biases? The general opinion about entrepreneurs is that they are risk takers. However, research showed that if entrepreneurs have to choose, they prefer to take moderate risks instead of taking decisions where there is high risk involved (Keenan and Lovable, 1994).This seems a contradiction, because the decision to become an entrepreneur is statistically a highs decision since over half of new ventures fail. In a study conducted by Cooper and colleagues their (1988), 95 per cent of the The interviewed entrepreneurs venture would did not entrepreneurs were convinced succeed. Where there is a complex interplay between feelings and thoughts which have awoken intense emotions. He concludes deal with that these entrepreneurs frequently situations that are new, unpredictable and complex. What kind of cognitive biases could an entrepreneur encounter?When we look at what kind of biases an entrepreneur can encounter, it needs to be known what kind of biases exist. There are dozens of known biases but not all an entrepreneurs will meet. We would like to discuss the biases that came across the most in research of cognitive threats of entrepreneurs. Optimism bias. The decision to become an entrepreneur is a crucial step that only can be taken if the entrepreneur is feeling optimistic about the chances of success. Because the chance of failure is statistically higher than success, entrepreneurs usually have an optimism bias.As mentioned before, 95 per cent of the entrepreneurs perceive the future of their new venture as being successful, while past studies of business survival suggest poor prospects for long-term survival for most new businesses (Cooper et al. , 1988). The optimism bias makes because entrepreneurs they see perceive less risk, more everything receive the new venture as a risk and their perception, rather than objective reality, explained the decision to start a current or future venture. That is why entrepreneurs do not necessarily have a higher risk propensity than other people (Keenan and Lovable, 1994).They simply perceive existing risks smaller than they are which shows that entrepreneurs are biased. Baron (2004) suggests that entrepreneurs are more often exposed to situations that test the limits of their cognitive capacities than other people. This i ncreases their susceptibility to various forms of bias or error. Baron argued that biases occur more frequently when individuals are confronted with more information than they can process at a given time, they face situations that are new to them and involve high degrees of uncertainty, and optimistically.In ‘The Evolution of Cognitive Bias', (2005) Hasten, Nettle, and Andrews state that where biases exist individuals draw inferences or adopt beliefs where the evidence for doing so in a logically sound manner is either insufficient or absent. In the case of 5 entrepreneurs however, we see that even if logical sound manner is sufficient still an entrepreneur can be biased. In the experiment by Cooper and colleagues (1988) 95 percent of the entrepreneurs was thinking that their venture would be a success, disappear when they knew about the objective chances.Business and Barney (1997) have stated that the optimism bias of an entrepreneur could also influence the stakeholders arou nd them as well. If the stakeholders wait until they attain all additional information, the opportunity they seek to exploit could be gone by the time this data is available. This means that the optimism bias of an entrepreneur can even overrule the rationality of other persons involved. Illusion of control The illusion of control gives the entrepreneur a sense of control that increases the likelihood of them acting on an opportunity, but at the same time it may blind them to genuine risks. Simon et al. 2000) The illusion of control states that decision makers often overestimate the personal control they have over the outcomes. This type of bias influences the ability for decision makers to actually make a decision. This could also be the reason many entrepreneurs fail even though they thought they had made a right decision. Belief in the Law of Small Numbers The belief in the law of small numbers is the use small off limited sample of to draw rim are conclusions. The bias makes peo ple believe samples information representative of the entire population from Overconfidence bias.Overconfidence refers to an unwarranted, high level of confidence (Forester and Scratchy, 2007). It is interesting that overconfidence can only be determined in retrospect, after an evaluation of knowledge, predictions and outcomes. Therefore, it will be difficult to notice beforehand if an entrepreneur is dealing with an overconfidence bias. Because of overconfidence, people do not take into account other factors and information that they need for decision-making. Goodness and Lecher optimism (2013), bias and argued distrust. Hat They the overconfidence bias is influenced by both the see overconfidence as a central theme in the failure of entrepreneurial firms with its effects magnified in combination with other cognitive biases. Which they are drawn (Simon et al, 2000). Simon and Houghton (2002) argued that belief in the law of small numbers may explain why entrepreneurs often overesti mate demand. The success of a small number of people in their own environment can make entrepreneurs think that they will also be successful, while the objective probability of success may be very low.Business and Barney (1997) mint out that entrepreneurs often use biased samples from a small number of friends or potential customers. Decision-makers versus Entrepreneurs Business and Barney mentioned that entrepreneurs are influenced by the sorts of cognitive biases that we all as individuals encounter (1997). However, they found that the extent to which people deviate from rational thinking may not be constant and that different individuals may utilize biases and heuristics to different degrees.They argued, and Baron (2004) agrees, that entrepreneurs in general are more susceptible to the use of biases and heuristics in decision-making. For entrepreneurs, the level of uncertainty in making decisions is higher than for general decision-makers (Humpback and Cozier, 1985; Covina and Sl iven, 1989). Also, general managers can approximate the rational ideal more closely because they usually have access to historical trends and past performance, while entrepreneurs do not. Several studies (Covina and Sliven, 1991; Garner et al. 992; Miller and Ferries, 1984) have shown that the context faced in decommissioning by entrepreneurs tends to be more complex than the context faced by managers. Pitfalls, biases and heuristics are likely to have more utility in hose highly complex decision settings faced by entrepreneurs, compared to the less complex context that managers face (Business and Barney, 1997). We find that entrepreneurs in general encounter, and until now no attempt has been done in making such a list. Simon et al. (2000) did make a selection in their research towards risk perception and the start of a new venture.They selected three biases that may lower risk perception when starting a new venture. Their research focused on the overconfidence bias, the illusion o f control and the belief in small numbers (see table 3). In their research optimism did not have a significant relationship with the decision to start a new venture, therefore they left this bias out of the model. Striking is that they left optimism out of their model, because they found a lack of significant relationship between optimism and the decision to start a venture.They mentioned however that other studies did encounter optimism affecting both cognition and behavior and explain that their outcome may have occurred because their survey measured optimism in a specific context. Further research on at least the optimism bias therefore is necessary. What influence can biases have on the success or failure of an entrepreneurial firm? Biases can have great impact on the success or failure of a company. Goodness and Lecher (2013) argued that their research shows that overconfidence can lead to disastrous effects in the entrepreneurial domain.In fact, they even found a strong relati onship between overconfidence and company failure, especially if overconfidence was linked with other biases. Also they found that optimism bias has a negative effect on firm survival, strengthening arguments on low risk perception and resultant propensity to fail. However optimism bias also acted positively on opportunity orientation. This is an important encounter more biases than other types of decision-makers, but no specific research has been done on framing the most common biases faced by entrepreneurs.In the field of strategic decision-making however, Hogwash described the 29 most common separate biases (1980). The ones that he considered most likely to affect strategic decisions are listed in table 1. An overview like this is missing in the field of entrepreneurship. One reason for this might be that most entrepreneurship common biases is hard to frame. Previous research did not mention a list of the that 7 finding, as one of the important aspects of entrepreneurship is find ing opportunities. Effective decision-making by entrepreneurs with respect to actions involving risk could play an important role in the success of new ventures.Empirical findings in literature about entrepreneurship offer support for the possibility that successful entrepreneurs are more effective at this task. Simon et al. (2000) found that effectiveness at decision making is an important factor in the performance of new ventures. Lovable and Keenan (1993) prescribed corrective measures to overcome the biases and achieve optimal behavior in every situation. Also Russo and Shoemaker (1989) reasoned that decision biases can be corrected through training.They have indicated that every decision-maker must, consciously or unconsciously, go through each phase of the decision-making process. They have stated ten most common barriers that entrepreneurs encounter in making good decisions. These barriers show resemblance with the biases described by Hogwash (1980). The availability bias, â €˜Judgments of probability of clearheadedly events are distorted', can be linked to the trusting shortsighted the most shortcuts, readily ‘relying or inappropriately on rules of thumb such as information anchoring too much on invention facts'.Both of them trust the most readily available information and thus the Judgment of probability may be distorted. Conservatism, which is the failure to sufficiently revise forecasts based on new information, can be linked to fooling ourselves about feedback, since in both cases the feedback will not be taken into account when forecasting new decisions, which can also emerge from being overconfident in making a Judgment. Russo and Shoemaker (1989) indicated that good decision-making can be broken down into four main elements: (1) framing; (2) gathering intelligence; (3) coming to a conclusion; (4) learning from feedback.Entrepreneurs have to keep track of what they expected to happen while guarding and against Lecher self-serving (2013) also explanations. Goodness agreed with the effectiveness of training on biases. They stated that for example the training of unrealistic optimists should stimulate the motivation to manage finances, to take advice, not to leave matters up to chance, and to understand the value of healthy distrust in oneself and others in non-routine situations.However, they also warned that training programs for entrepreneurs are not always a good idea. If it was not for the cognitive biases, start-ups would not occur as often as we observe now. Their advice for entrepreneurs is to balance the organization with people that are aware of these biases and can correct the entrepreneur where necessary. As well, Taverns and Keenan (1974) do not consider the biases as something that always should be eliminated.They argued that under conditions of environmental uncertainty and complexity, biases and heuristics sometimes also can be an effective and efficient guide to decision-making, simply because in such settings comprehensive and cautious decommissioning is not always possible. They state that biases and heuristics may even provide an effective way to Training When a bias causes harm, it is of critical importance that it can be addressed properly. Errors in decision-making can be extremely costs at not only the personal but also at the professional and societal level.As this article indicates, there does not seem to be an easy fix. Building further upon his previous work, Fishhook (1982) reviewed four strategies for reducing bias: (1) warning subjects about the potential for bias, (2) describing the likely direction of bias, (3) illustrating bias to the subject, and (4) providing extended training, feedback, coaching and other interventions. Fishhook concluded that these first three strategies yielded limited success, and that ‘even intensive, personalized feedback and training produced only moderate improvements in decision making. This model, derived from Wilson and Breake r (1994), shows how Judgmental biases are created and how they can be reduced. Awareness should first be created, there must be motivation to correct this bias and the direction and magnitude of the bias should be understood. As a final step, the bias should be removed or countered. But what is interesting is to see which techniques can be used to mitigate the bias of concern. We believe this can be done by applying a counter bias or by structuring the decision-making process.If decision makers rely less on intuition and emotion when making a decision, and more on deliberate and structured thinking processes, a decision can be made which approximates rationality. Analysis A list of the most common biases among decision-makers (note this it is not a list of the most common among entrepreneurs) have been framed earlier in this paper by Hogwash (1980). It is known that entrepreneurs are more susceptible to the effects of biases, but it is doubtful whether the most important biases for decision-makers are also the most important ones for entrepreneurs.The optimism bias and overconfidence decision-makers, bias do not appear on in the Hogwash's list of most common biases for while research cognitive biases of entrepreneurs mentions them often. The problem with making an analysis on the cognitive biases that entrepreneurs encounter is that there is no such a list of most common biases among entrepreneurs. Earlier in this paper, we accepted the definition by Stevenson and is Carillon several to (1990) modes that of entrepreneurship opportunities organizing without about creating resources through rage rd currently controlled.This made us not look at the traits of an entrepreneur, but at the processes of decision-making and biases that can occur. There are biases that every person encounters, but there are certain biases that have a more effect on decision-making but also have to be aware of different sorts of biases that can influence their perception of the world. Th is can be of great influence on the future of their new ventures. As Abide (1994) argued, there are three critical elements of successful entrepreneurial approaches.Entrepreneurs 9 have to screen opportunities quickly to weed out unpromising ventures, they have to analyze ideas in which they focus on new important issues and they have to integrate taking action and analysis. His most important conclusion is that entrepreneurs must reflect on the adequacy of their ideas and their capacities to execute them. This comes back to what we are addressing in this article. Can entrepreneurs be aware of adequacy of their ideas? And is it recommendable to create this awareness among entrepreneurs?To be able to have a better perception of the world and thus be better capable of reflecting and making decisions, biases are of great importance. Hen reflecting on the environment of the new venture and when making decisions based upon those reflections. Training programs to become aware of bias do e xist. Russo and Shoemaker (1989) proposed a training system in which good decision- making can be broken down into four main elements. In each element the person involved is encouraged to take the different barriers (table 2) into account so that he or she is guarded against silvering explanations.However, Goodness and Lecher (2013) argued that when entrepreneur are aware of biases, probably less start-ups will be realized. They advise that not the entrepreneurs will follow a raining program, biases. But rather people around the entrepreneur should be aware of existing Conclusion Although there are frameworks of individual cognitive biases in the literature of decision making, like the barriers by Hogwash (1980), there is no clear framework which cognitive biases entrepreneurs commonly encounter and how and if the effects of these biases should be reduced.The biases studied showed however that they can have big influence on the success or failure of a new venture. Goodness and Leche r (2013) found a strong relationship between overconfidence and company failure. Also positive biases strengthen low risk reception and increased the chance of failure. On the other hand, a positive bias in the startup phase of the company could be of great help because it strengthens the entrepreneur in motivation and opportunity finding.If entrepreneurs are aware of their biases, they could take this knowledge into consideration Taverns and Keenan (1974) pointed at the fact that not always should be eliminated. Under conditions of environmental uncertainty and in complexity, biases and simply heuristics because sometimes also can be effective and efficient decision-making, comprehensive and cautious decision-making is not always possible. Being aware of cognitive biases contributes towards obtaining optimal behavior in every situation.However, when we want to answer the question if awareness helps entrepreneurial firms perform better we would like to advise to also create awarenes s among the people around the entrepreneur and not the entrepreneur himself. The bias of an entrepreneur can be crucial in the start-up of a company and the motivation of other people. However, when a bias is harmful people around him can undertake action to 10 eliminate this bias and therefore reduce the chance of a company's failure. As a radical note we would like to mention that research on biases that an entrepreneur can encounter still has not been done.