Cognitive biases and venture formation
Mark Simon
Many possible types of actions might be con sidered a venture. Consistent with this article’s focus on entrepreneurship, it considers those actions that are high in innovation, risk, and proactiveness (Lumpkin and Dess, 1996), in cluding forming a start up company and intro ducing a pioneering product.
Many factors, including culture, demograph ics, and economics, promote the formation of a venture. Several scholars, however, have argued that one must understand the entrepreneur to understand why ventures are formed (e.g., Shaver and Scott, 1991). For instance, why out of hundreds who are laid off will only one person start a venture? Researchers initially addressed this question by examining whether entrepre neurs were more likely than others to have cer tain personality traits, a direction that has been characterized as a ‘‘dead end’’ by some (e.g., Gartner, 1985). More recent studies have explored the role of entrepreneurial cognitive pro cesses on venture formation (e.g., Krueger, 1993). This approach led to the conclusion that an individual’s perceptions regarding the feasibility and desirability of a venture influence the decision to form the venture. This finding, how ever, does not explain why individuals develop positive perceptions, even though many ventures fail and there is a paucity of reliable information upon which to reach a favorable conclusion.
To address this issue, researchers began conceptually and empirically to explore the relationship between cognitive biases and venture formation. Cognitive biases arise because people’s cognitive capacity is limited, so they can neither comprehensively search for, nor ac curatelyinterpret, information. They occur when individuals apply a rule of thumb that systematically violates the rules of probability and may lead to deviations from normatively derived answers (Hogarth, 1980). They also, however, assist people when making judgments that involve high levels of uncertainty, novelty, and time pressure – the very conditions sur rounding the decision to launch a new venture.
Research Exploring the Relationship Between Cognitive Biases and Venture Formation
The findings from three early empirical studies (Cooper, Folta, and Woo, 1995; Cooper, Woo, and Dunkelberg, 1988; Palich and Bagby, 1995) strongly suggest that a relationship between cognitive biases and venture formation might exist. Employing categorization theory, Palich and Bagby (1995) found that, when interpreting ambiguous scenarios, entrepreneurs were more likely than managers to perceive strengths and opportunities and less likely to perceive weak nesses and threats. The authors explained that these types of categorizations can often lead to distortion in information processing and might cause entrepreneurs to be excessively optimistic. This study, however, did not involve perception regarding the feasibility of a venture, but in stead focused on interpretation of technological changes, international trends, and competitive environments. An earlier study by Cooper, Woo, and Dunkelberg (1988) directly suggested that entrepreneurs were excessively confident of venture success, finding that over 80 percent believed that their ventures had a better than a seven out of ten chance of succeeding and a remarkable 33 percent were convinced there was no chance of venture failure. Furthermore, the authors’ analyses tentatively suggested that these inflated expectations were a function of cognitive biases. The authors found that the vast majority of the entrepreneurs rated their chances of success higher than that of entrepreneurs in similar businesses, suggesting they might suffer from a cognitive bias known as ‘‘ignoring base rates’’ (Tversky and Kahneman, 1974). Their predictions of success were also completely unrelated to objective factors typic ally associated with venture success, which could indicate that they suffer from an illusion of con trol. An illusion of control refers to an overestimation of one’s skills and consequently one’s ability to cope with and predict future events (Langer, 1975). A later study by Cooper, Folta, and Woo (1995) also suggested that entrepreneurs might not be employing fully cognitive biases and venture formation 33 rational decision processes. The research found that, the more unfamiliar entrepreneurs were with a field they were venturing into, the less information they searched for. This was especially true for novice entrepreneurs. These three studies, however, did not explicitly measure cognitivebiases.
Three later studies addressed this issue. Buse nitz and Barney (1997) examined overconfidence, that is, the failure to know the limits of one’s own knowledge, and representativeness, which is the willingness to generalize about a person or phenomenon based on only a few attributes of that person or phenomenon. The study found that entrepreneurs, compared with man agers, displayed these biases to a greater degree. Baron (2000) extended this stream by examining a cognitive phenomenon known as counterfactual reasoning. Counterfactual reasoning refers to reflecting on outcomes and events that might have occurred if the persons in question had acted differently or if circumstances had somehow been different. Similar to sunk costs, these thoughts about the past should not influence future decision making. The study compared differences in the extent to which entrepreneurs (persons who had recently started their own ven tures), potential entrepreneurs (persons who ex pressed a strong desire to start their own ventures), and non entrepreneurs engaged in counterfactual reasoning. Results indicated that entrepreneurs engaged in counterfactual reasoning less than other groups did, and experienced fewer regrets over past events. The article went on to propose that these tendencies generated positive affect states that may have led entrepreneurs to interpret situations positively, thereby contributing to their decision to start a venture.
In contrast, Markman, Balkin, and Baron (2002) determined that the patent inventors who founded ventures exhibited stronger regrets than those patent inventors who did not. The contradictory findings of the two studies could stem from the fact that non entrepreneurs in Markman and colleagues’ study were skilled and proactive enough to file a patent, so may have relatively little to regret in life. In contrast, the sample of potential entrepreneurs in Baron’s (2000) study included teachers, students, gov ernment employees, and individuals working in retail, who might have been less successful, sug gesting greater possible regrets. Importantly, all three of the studies compared biases of entrepre neurs with non entrepreneurs well after the ven ture was formed. While it is quite possible, and arguably even probable, that these biases played a role in the decision to form the venture, such an assertion nevertheless requires a leap of logic. The question arises, could the biases have arisen after the venture was formed? For example, Cooper, Woo, and Dunkelberg (1988) proposed that entrepreneurs overestimate the probability of success because they exhibit a bias known as post decision bolstering, whereby they exagger ate the attractiveness of an option after a decision is made.
This concern was addressed by three studies that measured biases at roughly the same time as the decision to form a venture. All three util ized subjects’ reactions to cases and/or scenarios. Using Masters of Business Administration (MBA) students, the first study (Simon, Houghton, and Aquino, 2000) examined the illu sion of control, overconfidence, and the belief in law of small numbers. This latter bias is closely related to representativeness and occurs when an individual uses a limited number of informa tional inputs (a small sample of information) to draw firm conclusions (Tversky and Kahneman, 1974). The research examined individual deci sion makers and found that both the illusion of control and the belief in the law of small numbers were associated with the decision to form a start up company. The study also deter mined that the relationship was mediated by risk perception. A follow up study by Houghton et al. (2000) compared the strength of these rela tionships at the individual level to their strength at the group levels by examining the responses of individual MBAs and teams of MBAs. Also, unlike the initial study, this research used the decision to introduce pioneering products rather than the decision to form a start up. Neverthe less, the basic relationships held across levels of analysis and with different dependent variables. In fact, at the group level, the belief in the law of small numbers generated even stronger relation ships. Finally, Keh, Foo, and Lim (2002) returned to testing the relationships at the indi vidual level, but utilized entrepreneurs rather than MBAs. They also added planning fallacy 34 cognitive biases and venture formation as an independent variable and used opportunity evaluation as the dependent variable. Despite these changes, the study generated findings that were similar to the earlier studies of Simon and colleagues. Planning fallacy, however, was not related to any of the variables in the model.
None of the three studies found a significant relationship between overconfidence and risk perception or between overconfidence and the dependent variable. The authors suggested this might have occurred because overconfidence was measured using diverse items that were not directly associated with the case decision. McNamara and Bromiley (1999) argued that researchers might make drastic errors in the design and interpretation of risk taking models if they fail to examine the issues managers actu ally attend to. This assertion not only indicates that the measure of overconfidence should re flect the decision being considered, but also sug gests the need for field studies that examine decisions in their natural environments.
A study by Simon and Houghton (2003) ad dressed these issues. It examined data from man agers of small computer companies around the time each company launched a new product to assess the extent to which the product was pion eering, the success factors the manager was fo cusing on, and the manager’s level of certainty in achieving each success factor. Eighteen months later the authors collected data to determine whether the new product introduction had achieved the specified success factors. If they were initially certain that they would achieve a success factor and did not, they were judged to be overconfident. The study found that over confidence was positively related to the degree to which product introductions were pioneering. While this study greatly advanced our know ledge of cognitive biases and their effect on entrepreneurial behavior, it should be noted that they examined only one cognitive bias, namely overconfidence, and one type of venture, namely pioneering a new product, and failed to address the mediating factor uncovered in previ ous studies.
Conclusion
Collectively, the discussion above strongly sug gests that cognitive biases do play a role in venture formation, but also indicates how much research is yet to be done in this area. For example, a theoretical article by Baron (1998) made a compelling case that researchers need to explore the effects of counterfactual reasoning, planning fallacy, affect infusion, attribution style, and self justification on venture forma tion. Five years later, entrepreneurship research has empirically examined only two of these five biases. A more recent theory piece by Simon and Houghton (2002) not only adds reasoning by analogy to the list of unexplored biases, but also more importantly suggests that the relation ship between biases and deciding to pursue a venture is much finer grained than previously suggested. The authors propose that the illusion of control, belief in the law of small numbers, and reasoning by analogy contribute to under estimating competition, overestimating demand, and overlooking requisite assets. These misper ceptions, in turn, lead to the decision to intro duce a pioneering product. Even out of the biases and relationships examined, only the rela tionship between overconfidence and pioneering has been explored in its natural decision envir onment at roughly the time the decision was made. It is our hope that this review not only illustrates what has been learned, but also serves to spur others to begin to further examine this rich area.
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