"Behavioral Economics" & Strategic Decision-Making

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.