Distortions and deceptions in strategic decisions
Companies
are vulnerable to misconceptions, biases, and plain old lies. But not
hopelessly vulnerable.
The chief executive of a large multinational was trying to decide
whether to undertake an enormous merger—one that would not only change the
direction of his company but also transform its whole industry. He had gathered
his top team for a final discussion. The most vocal proponent of the deal—the
executive in charge of the company's largest division—extolled its purported
strategic advantages, perhaps not coincidentally because if it were to go
through he would run an even larger division and thereby be able to position himself
as the CEO's undisputed successor. The CFO, by contrast, argued that the
underlying forecasts were highly uncertain and that the merger's strategic
rationale wasn't financially convincing. Other members of the top team said
very little. Given more time to make the decision and less worry that news of
the deal might leak out, the CEO doubtless would have requested additional
analysis and opinion. Time, however, was tight, and in the end the CEO sided
with the division head, a longtime protégé, and proposed the deal to his board,
which approved it. The result was a massive destruction of value when the
strategic synergies failed to materialize.
Does this composite of several real-life
examples sound familiar? These circumstances certainly were not ideal for
basing a strategic decision on objective data and sound business judgment.
Despite the enormous resources that corporations devote to strategic planning
and other decision-making processes, CEOs must often make judgments they cannot
reduce to indisputable financial calculations. Much of the time such big
decisions depend, in no small part, on the CEO's trust in the people making the
proposals.
Strategic decisions are never simple to
make, and they sometimes go wrong because of human shortcomings. Behavioral
economics teaches us that a host of universal human biases, such as
overoptimism about the likelihood of success, can affect strategic decisions.
Such decisions are also vulnerable to what economists call the
"principal-agent problem": when the incentives of certain employees
are misaligned with the interests of their companies, they tend to look out for
themselves in deceptive ways.
Most companies know about these pitfalls.
Yet few realize that principal-agent problems often compound cognitive
imperfections to form intertwined and harmful patterns of distortion and
deception throughout the organization. Two distinct approaches can help
companies come to grips with these patterns. First, managers can become more
aware of how biases can affect their own decision making and then endeavor to
counter those biases. Second, companies can better avoid distortions and
deceptions by reviewing the way they make decisions and embedding safeguards
into their formal decision-making processes and corporate culture.
Distortions
and deceptions
Errors in strategic decision making can
arise from the cognitive biases we all have as human beings.1These
biases, which distort the way people collect and process information, can also
arise from interactions in organizational settings, where judgment may be
colored by self-interest that leads employees to perpetrate more or less
conscious deceptions.
Distortions
Of all the documented cognitive
distortions, overoptimism and loss aversion (the human tendency to experience
losses more acutely than gains) are the most likely to lead people who make
strategic decisions astray, because decisions with an element of risk—all
strategic ones—have two essential components. The first is a judgment about the
likelihood of a given outcome, the second a value or utility placed on it.
When judging the likelihood of potentially
positive outcomes, human beings have an overwhelming tendency to be
overoptimistic or overconfident: they think that the future will be great,
especially for them. Almost all of us believe ourselves to be in the top 20
percent of the population when it comes to driving, pleasing a partner, or
managing a business. In the making of strategic decisions, optimism not only
generates unrealistic forecasts but also leads managers to underestimate future
challenges more subtly—for instance, by ignoring the risk of a clash between corporate
cultures after a merger.
When probabilities are based on repeated
events and can therefore often be well defined, optimism is less of a factor.
But loss aversion is still a concern. Research shows that if a 50–50 gamble
could cost the gambler $1,000, most people, given an objective assessment of
the odds, would demand an upside of $2,000 to $2,500.2Overoptimism
affects judgments of probability and tends to produce overcommitment. Loss
aversion influences outcome preferences and leads to inaction and
undercommitment. But the fact that overoptimism and loss aversion represent
opposing tendencies doesn't mean that they always counteract each other.
Loss aversion wouldn't have such a large
effect on decisions made in times of uncertainty if people viewed each gamble
not in isolation but as one of many taken during their own lives or the life of
an organization. But executives, like all of us, tend to evaluate every option
as a change from a reference point—usually the status quo—not as one of many
possibilities for gains and losses over time across the organization. From the
latter perspective, it makes sense to take more risks. Most of the phenomena
commonly grouped under the label of risk aversion actually reflect loss aversion,
for if we integrated most gambles into a broader set, we would end up risk
neutral for all but the largest risks. This truth has important implications
for strategic decision making.
Deceptions
The strategic decisions that companies
make result from interactions among their executives: a manager proposes an
investment, for example, and an executive committee reviews and evaluates it.
In this kind of setting, a conflict of interest often arises between an
"agent" (in this case, the manager) and the "principal"
(the corporation) on whose behalf the agent acts.3Such
"agency problems," which occur when the agent's incentives aren't
perfectly aligned with the principal's interests, can lead to more or less
intentional deceptions—misleading information provided to others—that compound
the problem of the agent's unintentional distortions. Recall the CEO who was
grappling with the big merger decision: trusting the protégé (the head of the
largest division) exposed the CEO to the risk that the merger's proponent was
not only overoptimistic but also attempting to further his own career by
exaggerating the deal's upside or underestimating its risks.
When companies evaluate strategic
decisions, three conditions frequently create agency problems. One is the
misalignment of time horizons between individuals and corporations. Several
consumer goods companies, for example, have noted that brand managers who
rotate quickly in and out of their jobs tend to favor initiatives (such as
introducing new product variants) with a short-term payback. These managers'
deception, intentional or not, is to advance only certain projects—those
aligned with their interests. The development of radically new products or
other important projects with longer payback times can rarely succeed without a
senior sponsor who is likely to be around longer.
Another problem that can generate harmful
deceptions is the differing risk profiles of individuals and organizations.
Consider a real-life example. A midlevel executive at a large manufacturing
company decided not to propose a capital investment that had a 50–50 chance of
either losing the entire $2 million investment or returning $10 million.
Despite his natural loss aversion, the chance of a 5:1 gain should have enticed
him into accepting the bet, and his superiors, for the same reasons, would have
deemed it attractive. Instead, he worried that if the investment failed, his
reputation and career prospects would take a blow, though he didn't anticipate
being punished if the investment was forgone. As a result, he decided not to
recommend it and thus in effect acted deceptively by not promoting an
attractive investment. This asymmetry between results based on action and
inaction is called the "omission bias," and here it magnified the
executive's loss aversion.
The final agency issue arises from the
likelihood that a subordinate knows much more than a superior does about a
given issue. Higher-ranking executives must therefore make judgments about not
just the merits of a proposal but also their trust in the person advancing it.
This is unavoidable and usually acceptable: after all, what more important
decision do CEOs make than choosing their closest associates? The tendency,
however, is to rely too much on signals based on a person's reputation when
they are least likely to be predictive: novel, uncertain environments such as
that of the multinational that went ahead with the megamerger. We call the
tendency to place too much weight on a person's reputation—and thus increase
the exposure to deception—the "champion bias."
Furthermore, the multinational's merger
decision exhibited an element of "sunflower management": the
inclination of people in organizations to align themselves with the leader's
real or assumed viewpoint. The CEO had expected to find dissenting voices among
his senior executives. But except for the CFO, they believed that the CEO
favored the deal and that the merger would proceed no matter what they said and
thus kept their doubts to themselves for fear of harming their careers. In
effect, they misled the CEO by suppressing what they really thought about the
deal.
Improving
individual decisions
Knowing that human nature may lead
decision making astray, wise executives can use this insight to fortify their
judgment when they make important decisions. To do so, however, they must know
which bias is most likely to affect the decision at hand. Exhibit 2 offers a
road map for the types of decisions where overoptimism or excessive risk
aversion will probably be the determining factor.
In general, the key to reducing
overoptimism is to improve the learning environment by generating frequent,
rapid, and unambiguous feedback. In the absence of such an environment—for
instance, when companies face rare and unusual decisions, which, unfortunately,
are the most important ones—there is a bias toward optimistic judgments of the
odds. The size of a decision determines the appropriate degree of risk
aversion. For major ones, a certain amount of it makes sense—nobody wants to
bet the farm. For smaller ones, it doesn't, though it often prevails for
reasons we'll soon explore. Companies should see minor decisions as part of a
long-term, diversified (and thus risk-mitigating) strategy.
As Exhibit 2 shows, companies don't always
rationally factor risk into their decisions. In the large, infrequent ones (for
instance, the industry-transforming merger that went horribly wrong)
represented in the exhibit's upper-left quadrant there is a tendency to take an
overly optimistic view. In essence, faulty judgments lead executives to take
risks they would have avoided if they had had an accurate judgment of the odds.
Since executives facing such a rare decision can't benefit from their own
experience, they should learn from the experience of other companies by
collecting case studies of similar decisions to provide a class of reference
cases for comparison.
Conversely, excessive risk aversion is
usually the dominant bias in the small but common decisions shown in the
exhibit's lower-right quadrant: good learning environments temper optimism, and
the human reluctance to bet—unless the potential gains are much bigger than the
losses—comes to the fore. A key factor in such cases is the tendency of
companies not to see individual projects within a stream or pool of similar
undertakings. If companies did so, they would move closer to risk neutrality.
Instead they tend to evaluate projects in isolation, which leads them to
emphasize a single project's outcome and thus to fear the losses. A
complicating factor, as we have already noted, is the possibility that the
decision maker expects to be blamed if an investment fails and thus has a more
risk-averse attitude than might be rational for a company, which can pool
comparable investments into an attractive risk-mitigating portfolio. Senior
executives sometimes fail to compensate for this bias, as they could by encouraging
a higher degree of risk taking in minor decisions, which are often made in
lower levels of the corporate hierarchy.
The remaining two cases in the exhibit are
relatively unproblematic. In large, frequent decisions—for example, a private
equity firm's deliberations about a new investment or the construction of a new
plant using existing technology—a significant degree of risk aversion is
sensible and the frequency of the endeavors offers ample learning
opportunities. In small, rare decisions optimism and loss aversion may
counteract each other, and by definition this class of decision is
comparatively unimportant.
Engineering
better decision making
Organizations don't all suffer equally
from distortions and deceptions; some are better at using tools and techniques
to limit their impact and at creating a culture of constructive debate and
healthy decision making. Corporate leaders can improve an organization's
decision-making ability by identifying the prevalent biases and using the
relevant tools to shape a productive decision-making culture.
Identifying
the problems
Corporate leaders should first consider
which decisions are truly strategic, as well as when and where they are made.
Applying process safeguards to key meetings in formal strategic-planning exercises
is tempting but not necessarily appropriate. Often the real strategic decision
making takes place in other forums, such as R&D committees or brand
reviews.
After targeting the crucial
decision-making processes, executives should examine them with two goals in
mind: determining the company's exposure to human error and pinpointing the
real problems. A decision-making safeguard that is useful in one setting could
be counterproductive in another—say, because it reinforces a high level of risk
aversion by enforcing hard targets for new projects. An objective analysis of
past decisions can be a first step: does the company often make overoptimistic
projections, for example?
Tools
against distortions and deceptions
Once companies undertake this diagnostic process,
they can introduce tools that limit the risk of distortions and deceptions. One
way of tempering optimism is to track the expectations of individuals against
actual outcomes in order to examine the processes (such as sales forecasts)
that underlie strategic decisions. Companies should review these processes if
forecasts and results differ significantly. They can also provide feedback
where necessary and show clearly that they remember forecasts, reward realism,
and frown on overoptimism.
A more resource-intensive way of avoiding
overoptimistic decisions is to supplement an initial assessment with an
independent second opinion. Many companies try to do so by assigning important
decisions to committees—for instance, the investment committees of investment
firms. If the members have the time and willingness to challenge proposals this
approach is effective, but committees depend on the facts brought before them.
Some private equity firms address that problem by systematically taking a fresh
look: after a partner has supervised a company for a few years, a different
partner evaluates it anew. A fresh pair of eyes with no emotional connections
can sometimes see things that escape the notice of more knowledgeable
colleagues.
Loss aversion, magnified by career-motivated
self-censorship of "risky" proposals, has its roots in explicit and
implicit organizational incentives. Lower-level managers typically encounter
more but smaller risks, so organizations can embed a higher tolerance for them
in certain systems—for instance, by using different criteria for the financial
analysis of larger and smaller projects.
Financial incentives also can be used to
counter distortions and related principal-agent problems. Many companies, for
example, find that operating-unit managers tend to optimize short-term
performance at the expense of long-term corporate health, partly because their
compensation is tied to the former and partly because they might well have
moved on by the time long-term decisions bear fruit. Some companies address
this problem through "balanced scorecards" that take both dimensions
into account. Others tie compensation to the performance of an executive's
current and previous business units.
Another technique is to request that
managers show more of their cards: some companies, for instance, demand that
investment recommendations include alternatives, or "next-best"
ideas. This approach is useful not only to calibrate the level of a manager's
risk aversion but also to spot opportunities that a manager might otherwise
consider insufficiently safe to present to senior management.
Finally, the radical way of counteracting
the loss aversion of managers is to take risk out of their hands by creating
internal venture funds for risky but worthwhile projects or by sheltering such
projects in separate organizations, such as those IBM sets up to pursue
"emerging business opportunities." The advantage is that norms can
change much more easily in small groups than in companies.
Fostering
a culture of open debate
It is essential to realize that these
tools are just tools. Their effectiveness ultimately depends on the quality of
the resulting discussions, which can't be effective unless the organization has
a culture of reasonably open and objective debate.
Shaping such a culture starts at the top,
as one chief executive discovered. This CEO was eager to encourage debate on
the strategic plans of his company's divisions but didn't want to put his
direct reports under pressure by publicly challenging them himself. He therefore
created a process intended to make all division heads challenge one another in
open debate. These managers refrained from voicing any real dissent, however,
so the result was a dull and pointless exercise. Later, they made it clear that
they had seen no upside in challenging their peers, given the company's
nonconfrontational culture and rigid organizational silos.
Although the CEO's experiment failed, he
was on the right track. A CEO in a health care company ingeniously solved a
similar problem by separating proposals from the proposers. Previously,
strategic options for the company's future were closely identified with their
most vocal proponents, so it was hard to conduct dispassionate debates. Instead
of having each executive present his or her favorite option, the CEO organized
a senior-management seminar where he asked each person to advocate another's preferred
strategy. Although everyone knew that the exercise was intentionally
artificial, it helped foster rational debate instead of a battle of egos. More
important, perhaps, it helped senior executives see the merits of other
strategies and led the group to adopt a plan that synthesized aspects of
several proposals.
One way to initiate a culture of
constructive debate is for the CEO and the top team to reflect collectively on
past decisions. A willingness to ask how they emerged—in effect, holding a
conversation about conversations—shows that the company can learn from its
mistakes.
Another prerequisite of good strategic
decision making is the ability to "frame" conversations in order to
ensure that the right questions get asked and answered. One key principle, for
instance, is clearly distinguishing a discussion meant to reach a decision from
one meant to align the team, to increase its commitment, or to support a
project champion. This elementary but often overlooked distinction may also
change the composition of the group that attends discussions intended to reach
decisions.
Once it becomes clear that a meeting has
been called to reach a decision, framing the discussion involves understanding
the criteria for reaching it and knowing how far the range of options can be
expanded, especially if the decision is important and unusual. Thus a
well-framed debate includes a set of proposed criteria for making the decision
and, when appropriate, an effort to demonstrate their relevance by providing
examples and analogies. Some companies also set ground rules, such as the order
in which participants voice their opinions or a ban on purely anecdotal
arguments or on arguments that invoke a person's reputation rather than the
facts.
Companies can't afford to ignore the human
factor in the making of strategic decisions. They can greatly improve their
chances of making good ones by becoming more aware of the way cognitive biases
can mislead them, by reviewing their decision-making processes, and by
establishing a culture of constructive debate.
By Dan P. Lovallo and Olivier Sibony
http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/distortions-and-deceptions-in-strategic-decisions?cid=other-eml-cls-mkq-mck-oth-1704&hlkid=67dadb1dd3f640bc8005116a021aa0a1&hctky=1627601&hdpid=5c23fe09-d7a0-4dea-80da-8d6f0964846e
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