Cognitive, biases, risk perception and venture formation: How individuals decide to start companies

Despite the high risk involved, thousands of individuals decide to start ve ntures. Past research, however, has found that entrepreneurs do not have a high-risk propensity, that is, a great willingness to knowingly take risks. This study, therefore, explores how individuals cope with the risks inhere nt in their decisions, and suggests that entrepreneurs may not perceive the riskiness of starting ventures. The study's findings suggest that risk perceptions may differ because certa in types of cognitive biases lead individuals to perceive less risk. Cognit ive biases are common types of mental shortcuts used to make judgments. Thi s study examines three cognitive biases that previous research has suggeste d may lower risk perception. The first, overconfidence, refers to the failu re to know the limits of one's knowledge. The second bias tested, the illus ion of control, occurs when individuals overemphasize the extent to which t heir skill can increase performance in situations where chance plays a larg e part and skill is not necessarily the deciding factor. Because the indivi duals believe that they can control largely uncontrollable events, they als o think they can accurately predict the outcome of the events. Finally, the third bias, the belief in the law of small numbers occurs when an individu al uses a limited number of informational inputs (a small sample of informa tion) to draw firm conclusions. This study's sample consisted of 191 students pursuing a Masters of Busines s Administration. The students' responses to a survey based on a case study regarding a decision to start a venture were examined. The survey included questions about the students' willingness to start the venture, their perc eption of the venture's riskiness, and the extent to which they exhibited c ognitive biases in their decision processes. The study's findings tentatively suggest that individuals start ventures be cause they do not perceive the risks involved, and not because they knowing ly accept high levels of risks. The belief in the law of small numbers lowe red an individual's perceptions of a venture's riskiness, suggesting that s ome individuals draw firm conclusions from small samples. An illusion of co ntrol also decreased risk perception, suggesting that individuals starting ventures might not acknowledge that certain tasks, important to the venture 's success, are beyond their control. Some argue that biases might be associated with venture failure. If this is the case, the very processes that increase the likelihood of starting a ve nture may actually decrease performance Entrepreneurs may choose to minimiz e their biases by soliciting and paying heed to the advice of outsiders, or by using group decision-making techniques, such as devil's advocacy or dia lectical inquiry. Others, however, suggest that early in the decision process, biases may be beneficial because they lower risk perception, which allows entrepreneurs t o generate the commitment needed for success. Even if this is mle, entrepre neurs should still institute processes to increase learning so the venture can adjust to unfolding realities and avoid any damage caused by initial mi sperceptions. Similarly, entrepreneurs need adequate safety nets in case th eir biases lead them to encounter unforeseen difficulties. The potential po sitive and negative effects of biases and perceiving low levels of risk sug gest the importance of exploring this area further. (C) 1999 Elsevier Scien ce Inc.