Although the entrepreneurial community tend to regard practical daily decision making of successful entrepreneurs as a good rule of thumb for effective decision making, empirical research has demonstrated the negative influence of cognitive biases on decision making processes of entrepreneurial venture. Writing in the Journal of Business Venturing, Simon, Houghton and Aquino demonstrate the working of cognitive biases on how individuals decide to start companies. A review of Simon, Houghton and Aquino, Cognitive Biases, Risk Perception and Venture Formation: How Individuals Decide to Start Companies, Journal of Business Venturing, 1999, 15, 113–134, demonstrates that illusion of control and belief in the law of small number are two critical cognitive biases affecting decision making in entrepreneurial venture formation.

A review of Simon and colleague research on effects of cognitive biases on entrepreneurial decision making demonstrates that while overconfidence dose not negatively influence entrepreneurial decision making, illusion of control and belief in the law of small numbers influence entrepreneurial decision making.

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In entrepreneurial settings overconfidence refers to an inability to grasp the limits of one’s knowledge base. Illusion of control in entrepreneurial settings refers to exaggeration of how well one’s skillset can solve and improve performance in situations where chance plays a larger role than skills. As a results, illusion of control can reduce one’s perception of actual risks involved.

Furthermore, belief in the law of small numbers, a cognitive bias that results in taking too few sources of information into account while arriving at a firm conclusion, leads to examining only positive signals when heading into a new venture. Belief in the law of small number is a serious form of cognitive bias in entrepreneurial decision making because it leads entrepreneurs to consider only positive information and not expanding their research into sources that demonstrate unfavourable information about the venture.

Simon, Houghton and Aquino found that both illusion of control and belief in laws of small number influence risk perception, that is, these two cognitive biases distort risk perception, lowering perception of actual risk involved in new ventures. In summing the practical implications of their study, Simon, Houghton and Aquino underscore that entrepreneurial hubs and organizations providing entrepreneurial resources should carefully balance the dissemination of information not over-emphasizing risky success stories.

Research reviewed

Simon, Houghton and Aquino, Cognitive Biases, Risk Perception and Venture Formation: How Individuals Decide to Start Companies, Journal of Business Venturing, 1999, 15, 113–134

The important role entrepreneurial activities play in stimulating economic growth is undoubtedly clear and hence research in entrepreneurship has attracted much attention. An interesting line in this research is entrepreneurial way of thinking. Is there anything special about the thinking process of successful entrepreneurs? A review of Krueger, Reilly and Carsrud article entitled Competing Models of Entrepreneurial Intentions, Journal of Business Venturing (2000) shows that personality and environmental parameters are not as powerful predictors as entrepreneur’s intention and hence this research underlines the importance of closely studying the venture formation phase in relation to core intention of the founder. Krueger, Reilly and Carsrud (2000), argue that entrepreneurial activities are primarily about a way of thinking that emphasizes opportunities over threats.

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Entrepreneurs’ perception balancing in favour of opportunities certainly emerge from an optimistic view entrepreneurs tend to have about the outcome of the venture. It is also interesting to note that other researchers have demonstrated that entrepreneurs tend to frame risks within personal value system and hence a greater risking taking behaviour is rationalized within personal value system. That is, personal value system tend to cushion perception of risking taking (see, Sarasvathy, Simon and Lave, 1998). For example, a high-rise window cleaner’s perception of the risks involved in his small business may certainly be cushioned by leisure activities as a rock-climber. This is exactly where the intention model of entrepreneurial activities help us better understand factors that influence formation of new venture ideas during the planing phase, namely, personal value systems, emotion and motivational drivers of the founder.

Readings
Krueger, N.F., Reilly, M.D., and Carsrud A.l. (2000). Competing models of entrepreneurial intentions. Journal of Business Venturing. 15 (5–6): September–November issue, pp. 411-432
Sarasvathy, S., Simon, H. and Lave, L. (1998). Perceiving and managing business risks: Differences between entrepreneurs and bankers. Journal of Economic Behaviour and Organization, 33(2): 207-226