People Are Subject to Behavioral Biases
When you’re dealing with corporate finance, you rely on the collection and analysis of data to help you answer questions and make decisions. Even though all the data you need to make the best decision may be available, how you actually perceive and use that data can be an erroneous process thanks to the following two types of bias:
Statistical bias: This type of bias occurs when people collect data from a sample rather than an entire data set and then assume that the data they collected represent the entire data set. Say that a financial analyst wants to assess the returns on capital investment that a company is able to generate.
If he takes his data only from the marketing department of the company rather than from every department, his analysis is going to be biased.
Cognitive bias: This bias occurs during the processing of information as people choose to use their own personal judgment rather than the data results. Cognitive biases come in a variety of shapes and sizes:
Status quo bias refers to peoples’ tendencies to avoid changing established methods, such as when a team of employees refuses to implement a more efficient inventory management system just because they don’t want to learn the new system.
Self-serving bias refers to people’s tendency to give themselves credit for successes but blame outside factors for failure. This type of bias contributes to erroneous self-assessments of investing performance.
Confirmation bias refers to the tendency of people to acknowledge only data that confirm their preconceived beliefs, resulting in the rejection of any truths that challenge their beliefs. This type of bias can devastate a company when it leads management to ignore its analysts.
Corporate finance relies heavily on accuracy of data and the precision of analysis. Although individuals are constantly subject to multiple types of biases, companies can reduce the rate of error due to bias by maintaining proper data collection methods and utilizing full analyses. The key is to interpret only what has actually occurred instead of letting personal judgment influence decisions.