At the intersection of strategic decision-making and human
shortcoming is behavioral economics, which teaches that a host of biases,
such as overoptimism about the likelihood of success, the "principal-agent
problem," and undue loss aversion, combine to form "intertwined
and harmful patterns of distortion and deception throughout the organization." At
least if you believe McKinsey.
Actually, I’ve long been fascinated, if not baffled and
perplexed, by why such a dismaying proportion of bet-the-firm strategic
decisions pan out in pain and recrimination rather than celebration and
triumph. What I’m about to describe cannot inoculate you or your
firm from these problems, but a street-wise "heads-up!" cannot hurt. Plus,
these innate human biases are applicable across the board, including
to your daily life.
Let’s begin with the (now) well-established economic/psychological
proposition that human beings are irrationally averse to losses, as
compared to fond of gains. What exactly does that mean? Logically,
if you are offered a (free) gamble with a 50/50 chance of winning $1,000
or losing $1,000, you should be preference-neutral on taking it; rationally,
you might just flip the $1,000 coin. But studies consistently show
that people won’t take the gamble until the upside is $2,000 to $2,500
(the downside remaining -$1,000, of course).
In an organizational setting, this means that "loss aversion"
consistently leads people to inaction and undercommitment to opportunities. If
you’re a lawyer reading this, your instinct might be, "Well, that’s not
such a bad thing, is it? It makes sense to take the cautious and
prudent course."
Here’s the rub: The "reference point" from which
to judge this gain/loss metric should not necessarily be the
status quo. What makes the status quo sacrosanct? Put
differently, unless your firm is optimal in all possible respects, some
change is in order. Do not conflate "loss aversion" with "risk
aversion." Loss aversion is not just "prudent," it’s
a survival mechanism. But risk aversion is what gets one-time
titan firms like Digital Equipment Corp. into Chapter 11 and GM
into junk-bond status.
The "principal-agent problem?" Simple: The
"principal" is your firm, and the "agent" is the partner, C-suite executive,
or other critical recommender/advisor. Now suppose (a McKinsey
real-life example) a capital investment has a 50/50 chance of losing
its entire $2-million investment or returning $10-million. 5:1
odds sound good, right, and wouldn’t you as king approve such an investment,
"holding the partner harmless" if it doesn’t pan out?
But consider it from the partner’s perspective. What
kind of a blot would it be on your reputation to throw away $2-million
of the firm’s (and your partners’) money? And for how long would
you be remembered as a hero if you collected the $10-million return? Now
you want me to recommend the rational choice? I don’t think so….
One more wrench in the gears before we suggest a palliative: The
"champion bias." This simply refers to the tendency to
place excessive weight on an individual’s reputation for trustworthiness
within the organization. Now you’re really protesting! If
senior management hasn’t figured out who to trust, what on earth have
they been doing? Isn’t part of the job description to select, groom,
and promote trusted advisors?
To be sure, but we’re evaluating "trustworthiness" in,
by hypothesis, a new context: Not the day-to-day operational
routines at which they presumably excelled and for which they were
selected and promoted, but in the context of a large strategic decision
where their judgment is not presumptively better or worse than others
who have similarly not been called up on to make such judgments. The lesson
is:
- Solicit a variety of viewpoints
- Invite dissent and hard questioning
- Do not permit suppression of what people really think
I know; "easier said than done," you’re saying. Well,
can we at least say anything systematic about how human
biases tend to affect decision-making, the better to be on guard against
it? Behavioral economics says we can.
To oversimplify life, assume there are two kinds of decisions: The
rare, infrequent, but very large decisions (M&A, expansion overseas),
and the routine, serial, smaller decisions (hiring a new lateral, incrementally
expanding a practice area). Perhaps counter-intuitively (but actually
not, once one thinks about it), the tendency is to be overoptimistic on
the rare big bets and overly loss-averse on the little
serial decisions. Why?
Essentially—and who would really want it otherwise?—people
approach matters overestimating their skill. Ranking themselves,
virtually every one puts themself in the top 20% of drivers, honest people,
faithful friends, etc. So even if (as many studies of corporate-land
have it), 70-80% of mergers fail to add value, "we’ll be different!" kicks
in. Combine that with the understandable tendency to hope for the
best, to suppress dissent once such a transformational decision starts
to gather momentum, and finally the lack of experience with such efforts,
and overoptimism rules.
Compare that to the small, regular decisions: Here, firms tend
to be oblivious to the fact that these decisions constitute an ongoing
stream of investments—a "portfolio," if you will, of projects and
undertakings. Correctly analyzed, a diverse portfolio is devoutly
to be desired, and everyone knows that will entail some losers, or at
least some counter-cyclicality among its elements. But the problem
is that the firm rarely stands back (that’s the Managing Partner’s job)
and looks at these lateral hires or practice group expansions as a "portfolio." Instead,
the individuals responsible for pulling the trigger on each move evaluate
the initiative in isolation, fear possible losses, and expect to be blamed
if it fails. Here we are right back at the "principal-agent problem."
Now what? Well, lawyers are into nothing if not process, so let
me suggest some procedural tools (understanding they are only tools and
not cure-alls) to get around these systematic biases. Here are
a few:
- separate the small, serial decisions from individuals and entrust
them to a "venture investment committee" with a conscious mandate to
construct a diversified portfolio of new initiatives for the firm - separate the proposal from the proposer, to take politics and personality
out of it (or at least to help suppress it); for example, at a senior
management retreat, assign people to advocate someone else’s strategic
recommendation: Although somewhat artificial, it can turn an
ego battle into a more rational debate - take time to collectively reflect on and analyze past decisions;
are there any detectable systemic errors? - be crystal clear about the purpose of a discussion: Some are
meant to reach the ultimate decision, others are meant to brainstorm
about alternatives, still others are meant to help the team coalesce
once the decision has been made, and to drive towards the goal. Having
clarity about such things is remarkably simple, and remarkably oft
overlooked.
And lastly, have courage and be of good cheer. These decisions,
made over the course of years or even of a career, will do nothing less
than mold the firm, but mid-course corrections are allowed, and if you
can admit error at the same time you celebrate wins, you should get to
come back to bat again and again.
p.s. Yes, this is a long post: But this stuff matters.
