Systematic Errors in Corporate Decision Making

It is the earnings release season for many tech companies and as an audience it is a great opportunity to learn how past decisions impact the current financial results. Hindsight being 20/20, rationality of past executive judgments are on show for shareholders to evaluate. Repeated mistakes resulting in lost shareholder value are common occurrences in corporate history. The advances of technology and our understanding of the world around us has not really changed this phenomenon. It seems to me that the forces of evolution did not design our intelligence to make futuristic financial decisions. In the Savannas our ancestors developed superior skills to survive in the face of present danger and did not need any futuristic numeric literacy to run from a predator.

In 2.5 million years of human history, the first use of numbers was found just about 5400 years ago (Mesopotamian base 60 system in ca. 3400 BC). In the context of human evolution timeline, our instincts and behavior for making financial decisions are very recent and have not fully developed yet. Scientific research shows we make systematic errors in numeric / financial decisions and are heavily influenced by cognitive biases that result in poor decisions.

Few years back I watched this TED Talk and got interested in the field of Behavioral Finance / Behavioral Economics and read few books on the topic. Notable among which are Predictably Irrational by Dan Ariely; Judgment in Managerial Decision Making by Max Bazerman and obviously one of my all-time favorite Thinking Fast and Slow by Daniel Kahneman.

There are hundreds of systematic errors and predictable biases that we know of today. I am writing about only three errors / biases that I read in the press and see all the time, especially those that combine together seamlessly resulting in extremely poor decisions in the corporate world.

Illusion of Control – Things are different when I am in control

Illusion of control is the tendency for humans to believe they can control or at least influence outcomes that they demonstrably have no influence over.

Examples – People believe they are less likely to get into a car accident if they are driving. People believe that their actions have influence over games of chance whose outcome is entirely random such as throwing dice, betting on cards, striking big on slotting machine, etc. People wear “lucky” clothes and follow some  superstitious routines before games, exams, etc.

Decision Making Lessons – Corporate executives in powerful positions routinely overestimate their capacity to turn acquisitions into  game changers; introduce new products and disrupt an entire industry; establish new partnerships and become market leader etc. Such tone at the top naturally percolates down the organization and creates a sense of ‘Illusion of Control’ across all functions that support such leader. As a result, role of potential risks, randomness, opposing market forces are generally ignored in the financial due diligence process resulting in sub-optimal decisions.

 Optimism Bias – The triumph of hope over experience

Optimism Bias is the human tendency to be positive and hopeful rather than realistic. People tend to be overly confident about the future; they overestimate the chance of positive events and underestimate the chance of negative events.

 Examples – 100 % of the people who buy lottery tickets think they have a strong chance of winning the prize, which in reality the odds are about 1 in 175 Million tickets (Powerball).  More than 80% of MBA students think they will be within the top 5% of students accomplishing great financial success in the next 5 years. Newlyweds expect 0% chance of getting divorced when in reality there is about 40% chance.

Optimism Bias is hardwired into us by evolution. Optimism / hope keeps our minds at ease, lowers stress and improves physical health. A study of cancer patients revealed that pessimistic patients under the age of 60 were more likely to die within eight months than optimistic patients of the same initial health, status and age. Optimism bias is a coping mechanism that is essential for survival.

Decision Making Lessons – This bias however operates adversely in corporate decisions. Similar to marriage, acquisitions, partnerships, new product launches, etc. are generally assumed to have a failure rate of 0% – otherwise the decision defeats the intent. This bias coupled with ‘Illusion of Control’ results in overoptimistic financial models, rosy forecasts and overconfident tone from the top. Even in the face of negative experience with similar situations, hope for a better future always triumphs. Optimism spreads systematically across decision makers, their organizations and gets embedded in functions and processes. Optimism in the corporate context clouds objectivity and rational decision making.

Confirmation Bias – Reach conclusions first and gather facts later to prove the conclusion

Confirmation bias refers to a type of selective thinking whereby one tends to notice and look for what confirms to one’s beliefs, and to ignore, not look for, or undervalue the relevance of what contradicts one’s beliefs.

Examples – Journalists write only about facts, data and opinion that suits their headline ignoring all contradictory information. Product researchers generally look for confirming evidence of success and consider negative evidence as remote use cases. Preferable candidates on job interviews generally do not get grilled and their weaknesses are ignored.

Decision Making Lessons – Similarly in an effort to please the corporate leadership and demonstrate commitment to organizational goals, employees generally structure their analysis, research and proposal in-line with the decisions / preferences of the leadership. This bias results in employees filtering out potentially useful facts and opinions that don’t coincide with their preconceived notions of the management.

While we like to imagine that our beliefs are rational, logical, and objective, the fact is that our ideas are often based on paying attention to the information that upholds management ideas and ignoring the information that challenges popular beliefs within the corporate echelons.

It is very difficult to get rid of our evolution driven systematic errors and biases especially at an organizational level. Recognizing our limitations and developing awareness about our fallibility is surely the first step and perhaps that gives us another chance to not repeat the same mistakes again.

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