How statistics can guide better business decisions
Management | 12 May 2021
We make thousands of decisions every day. For some of the more mundane, we barely realise we’re making them. In business, we sometimes dwell on decisions for hours, days, or even months. We know that these decisions have the power to change the course of our business, so it’s important that we get them right.
For most of us, we judge a decision purely by outcome. A good outcome may be thought of as an inspired decision, one made because of good judgement. Whereas if it’s a bad outcome, then we often attribute it to bad luck. What we don’t often recognise is the role of luck in the good outcomes we achieve – this is often an uncomfortable truth.
To make better decisions, we need to examine how we make them and become comfortable with the role that luck plays in that. The study of probability, statistics, can yield some unique insights.
Errors: a statistical insight
Statisticians study luck through probability – which means there is a tonne of insight to be gained from even the most basic understanding of probability and statistics.
One of the approaches we can take in decision making is to avoid error. Statisticians classify errors into two categories: type I and type II.
A type I error is the rejection of a true null hypothesis, i.e. a false positive, like finding an innocent person guilty of a crime. Type II errors represent a false negative, where a guilty individual would be found not guilty.
Type I errors are often more severe, as we need to deviate from the status quo in order to reject a hypothesis. In business, this is often associated with cost – allocating resources, making investment and accumulating other costs.
Why do we make errors?
One aspect of decision making we need to accept is that avoiding error is difficult, if not impossible. There are a number of reasons for this – and it’s also why we can’t compare strategic business decisions to those made in a board game like chess. For example:
We don’t have perfect information. In chess, a skilled player understands the rules, moves and strategies that can be added. In real life, we lack this same clarity.
There’s a lot of deception. In chess, while the underlying strategies won’t be known, all moves are visible to both players. In real life, we're subject to disinformation, untruths and falsehoods.
Luck plays an important role in determining the quality of an outcome.
You can’t always look back and assess the quality of your decisions because of the role of luck. In chess, you can look back on moves that led to a loss, there are few external factors limiting our ability to play a move.
So if we recognise that we are going to make errors, what tools and mental models can we use to avoid them as much as possible?
How do we use this insight to make better decisions?
“Thoroughly conscious ignorance is the prelude to every great decision made” – James Clerk Maxwell.
In life, as in business, there are going to be more things we don’t know, than things we know. Ignorance drives science and is one of the reasons scientific researchers follow the scientific method: we make an assumption (hypothesis) and, only then, do we seek to prove that hypothesis wrong. Science exists to disprove hypotheses and overcome ignorance.
Being clear in your own understanding of the matter at hand is essential, you need to acknowledge your expertise in the subject matter. From this, you should have a transparent view on just how unsure you are, what the possible outcomes are (if known) and its probability. With this knowledge, you can arm yourself with more ammunition to take a more informed decision.
Avoid loss aversion
Kahneman, in Thinking Fast and Slow, discusses how the bad feeling of a loss and the good feeling of a win are not equal. In fact, a loss feels about twice as bad as a win does good.
In decision making, being right feels like winning, but being wrong feels like losing. We don’t like to admit we’re wrong – so if we are, it must just be bad luck. And if we are right, we must just be smart people. No, we must recognise all of the other factors that contribute to a loss – luck, a lack of knowledge, or various other external factors.
Treat decisions as you would a bet
Weigh up decisions as bets. Treat the probability of the outcome in accordance with the risk that comes with losing. Bets are choices we make based on what we think will probably happen.
In leadership, this can be extended out to decisions. Decide upon the alternative futures, then flesh these out with benefits and risks. The biggest risk that presents us is typically the opportunity cost, because a decision commits us to a course of action. In most instances, the bet we are making is against ourselves.
Forming beliefs and gaining new insights
One of the best strategies for improving your decision making is to use your experiences to update your beliefs. When we learn information, we do not normally use any extra mental energy to think about it, vet it, determine whether it's fact or fiction, and then act upon it.
As highly social animals, our inclination as humans is to believe by default. It’s why fake news and misinformation has been such a problem over the past few years. It has been evolutionary advantageous to be efficient, rather than accurate. But in the modern world, being accurate is just as important.
Why can this be difficult?
There's a lot riding against us
Stubbornness. Once a belief is lodged, it becomes difficult to dislodge.
Paradoxical thinking. If we think of beliefs as only 100% right or 100% wrong
Intelligence and narratives. The smarter you are at constructing a narrative that supports your belief.
Narrow Framing. Unduly limiting your options and spotlight.
Confirmation bias. Seeking out information that confirms our belief.
Overconfidence. Having too much faith in our predictions.
Commitment bias. Once we have an idea, we tend to stick by it.
Past association. Previous experiences shape our future ones: we may make sloppy associations in the past that haze our thinking now and in the future.
So how do we make better decisions?
“If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest. You're giving a huge advantage to everybody else” – Charlie Munger
Charlie Munger, vice-chairman of Berkshire Hathaway, tells us we need to understand the numbers behind our decisions. Treating them as bets encourages us to take a more scientific approach to our decisions, enabling us to think in probabilities and visualise the future more thoroughly.
There are some other quirks that we can also leave you with, for example: Avoid coming from behind. If you lose the first match in a series of 7, your probability of winning falls to 34.35%. If you then go on to lose the second, this probability falls to 18.75%. Getting in an early victory will stack the odds in your favour.
So in order to make better decisions, we need to understand the probability that our decisions will compound those returns to the business. This makes cost-benefit analysis absolutely critical, especially when making hiring decisions.