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What we should tell entrepreneurs about risk

Success is really the exception, but there are strategies to make it more likely

Editors note: This article was originally published on James Breiner: Entrepreneurial Journalism website. Mr Breiner also creates My News Biz newsletter, that in-depth covers the major media topics. You can sign up for the newsletter here.

Recently I read an enlightening book by Daniel Kahneman, a Nobel-prize-winning economist – Thinking, Fast and Slow. The book is filled with rigorous economic and psychological studies of how our instincts and reason mislead us, especially when we are dealing with statistics.

His goal in writing was to improve our ability to identify and understand errors of judgment and choice, in others and ourselves. Much of the book, a bestseller since 2011, has great relevance both for entrepreneurs and people like us who coach them. What I plan to do is walk you through some common mistakes Kahneman and others describe and then suggest some solutions.

Outcome bias

Most of the stories we tell media entrepreneurs are success stories, and my own research is full of such examples. Our goal is to try to identify some common elements among these success stories that entrepreneurs can use in charting a path forward. The old business models don’t work, so we have to try to identify new ones.

There is a problem with this approach, Kahneman says: “The explanatory stories that people find compelling are simple; are concrete rather than abstract; assign a larger role to talent, stupidity, and intentions than to luck; and focus on a few striking events that happened rather than on the countless events that failed to happen” (p. 199, Kindle edition).

For example, the story that is told about Google’s founders, Larry Page and Sergey Brin, is one of plucky entrepreneurs who outsmarted everyone and built a trillion-dollar company from a startup in garage. However, Kahneman reminds us that a year after founding the company, they were willing to sell it for less than $1 million. “[B]ut the buyer said the price was too high” (p. 200).

By focusing on the outcome–Google’s global dominance–we tend to ignore how the story might have been different if the founders had sold the company in its early days. No one would be celebrating them today as brilliant entrepreneurial geniuses.

Kahneman also demonstrates the outcome bias in two popular business books: “On average, the gap in corporate profitability and stock returns between the outstanding firms and the less successful firms studied in Built to Last [1994] shrank to almost nothing in the period following the study. The average profitability of the companies identified in the famous In Search of Excellence [1982] dropped sharply as well within a short time” (p. 207).

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Optimism helps entrepreneurs

Another way the entrepreneurial community misleads itself is with excessive optimism, Kahneman says. But it has its upside: “Because they misread the risks, optimistic entrepreneurs often believe they are prudent, even when they are not. Their confidence in their future success sustains a positive mood that helps them obtain resources from others, raise the morale of their employees, and enhance their prospects of prevailing. When action is needed, optimism, even of the mildly delusional variety, may be a good thing” (p. 256).

When he chats with entrepreneurs, Kahneman finds that they never estimate their chances of success as less than 80%. They think their fate is almost entirely in their own hands.

“They are surely wrong: the outcome of a startup depends as much on the achievements of its competitors and on changes in the market as on its own efforts” (p. 260).

Optimism and the ability to tell a great story certainly helped Adam Neumann of WeWork lure investors into pouring $10 billion into a company that turned out to be wildly oversold and overvalued (not an example Kahneman used).

How biases mislead entrepreneurs

The mental errors of entrepreneurs are laid out in detail by Stephen X. Zhang and Javier Cueto, who draw heavily on Kahneman’s research in their paper “The Study of Bias in Entrepreneurship”.

They point out that several aspects of startups contribute to mistakes in judgment: the uncertainty of outcomes, the speed in which they have to make decisions, and information overload. Some of the mental biases they describe:

  • Overconfidence: they place more importance on possible positive outcomes than negative ones. It can lead to excessive risk-taking.
  • Illusion of control: they overemphasize how much skill, rather than chance, is the reason for improved performance.
  • The law of small numbers: they reach conclusions about a large set of cases using a limited sample.
  • Availability bias: they make judgments about the probability of events based on how easy it is to think of examples.
  • Escalation of commitment: they persist unduly with unsuccessful initiatives or courses of action.

Course correction: judgment honed by experience

In contrast with the 80% certainty of success expressed by optimistic entrepreneurs is the estimated 80% failure rate for startups. This is where experienced coaches can help them avoid mistakes. Entrepreneurs have a narrow “inside view” of their operations, as Kahneman would describe it. They need the “outside view” of those who have seen many more cases, many more strategies, and many more outcomes.

Experience helps offset mental mistakes the most in environments that are “sufficiently regular to be predictable” and offer “an opportunity to learn these regularities through prolonged practice”. Nurses, physicians, firefighters, chess players, and athletes all operate in such environments, Kahneman says (p. 239).

Unfortunately, startups operated by entrepreneurs are not always “sufficiently regular to be predictable”. Other tactics have to be used.

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Build, measure, learn, pivot

Different strategies have to be used in the entrepreneurial environment, given its uncertainty and unpredictability. Author and consultant Eric Ries has elaborated a model in The Lean Startup, which he began as a book and has transformed into a multi-pronged consulting business.

The process Ries recommends for entrepreneurs is to get their product into the hands of target users as soon as possible, even if it is simple and primitive–a minimum viable product. Then test users’ reactions, measure the results, and make adjustments. The steps are build, measure, learn, and pivot.

The Lean Startup model requires continuous experimentation and iteration. Experiments that work (or don’t) aren’t successes or failures but “validated learning“. And it is this learning that creates value for the startup.

For the entrepreneur whose venture fails, this validated learning can be carried into the next venture. In Silicon Valley, failures are viewed as essential stepping stones on the road to success.

A cure for overconfidence

When starting any project or venture, the participants should engage in a truth-telling exercise, Kahneman says. Rather than holding a meeting and asking everyone’s opinion on the venture, he recommends this: “Imagine that we are a year into the future. We implemented the plan as it now exists. The outcome was a disaster. Please take 5 to 10 minutes to write a brief history of that disaster” (p. 264).

This exercise requires people to think about the possible weaknesses of a plan rather than focusing on its benefits. It tends to eliminate the overconfidence bias by eliciting pitfalls that might have been overlooked. The team will be better prepared to execute the plan.

As Kahneman mentioned, confidence and optimism help entrepreneurs acquire the resources they need. But people like us–the coaches and trainers–shouldn’t mislead them into thinking the path forward is easy. We need to remind them of the pitfalls so they can avoid becoming part of the 80% who fail.

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Photo by Cristofer Jeschke on Unsplash

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