How we regularly make poor strategic decisions without even realising, and what to do about it (3/4)

In our first two posts in this series, we discussed how "cognitive traps" help us fool ourselves into thinking we're making rational decisions, when the opposite is true. We covered six common traps and their sometimes disastrous consequences. In this post we cover the final four of our ten traps.

Trap 7: “Overconfidence in calibration”

In this trap, people under-estimate the potential range of possible outcomes. In particular, people are often not sufficiently pessimistic with downside scenarios and/or attach too low a likelihood to major problems and pitfalls.

This issue is rife in business planning and financial projections. The more discrete and separate a business unit, the more visible is the variability; groups of partially-related businesses can appear easier to predict just because of the averaging of different under- and over-performing units. We often see business plans that overall are at or slightly below target, but consist of component businesses that show enormous variations from the original projections. For some reason, we as managers believe in our ability to perform within a tight range of projected expectations, despite this consistent evidence to the contrary.

Trap 8: “The fallacy of conjunction”

This is a trap in which people overestimate the likelihood that a series of highly likely events will all occur, and conversely underestimate the likelihood that at least one of a series of unlikely events will occur.

This leads management to believe that its mid-case scenario (which consists of all those highly likely events) is much more likely to happen that it actually is. The corollary is that it is reasonably likely that at least one of the many highly improbable, left-field, events will occur, and management will correspondingly be less likely to be ready for it.

We see this fallacy most often, again, in business planning, where a great deal of thought and preparation is given to the central scenario in the business plan, which from historic experience very rarely turns out to be true. It is why we at Latitude see business planning as a helpful process to prepare for possible futures, but see business plans as simply a means to this end.

Trap 9: “Failure of invariance”

This trap recognises that people are risk averse when prospects are positive but risk-seeking when they are negative. In a famous experiment, the vast majority of participants preferred a 100% chance of winning 500 pounds versus a 50% chance of winning 1,000 pounds. The same group preferred a 50% chance of losing 1,000 pounds versus a 100% chance of losing 500 pounds.

Companies approaching distress or who have experienced the initial failings of an investment seem to follow this risk-seeking tendency by trying ever more unlikely approaches to getting back their original money. It is almost always more rational and loss-minimising to write off sunk cost or a percent of equity, and to look at each decision on its own merits without the need to regain lost ground. Using share options as a reward mechanism can exacerbate this problem by actually making the risk-seeking rational for the individual manager, incentivising to act against the best interests of other stakeholders.

The other side of this coin, risk aversion when the company is ahead, is also very common and can lead to tremendous lost opportunity in new areas of business. This can be such a strong mindset in the team that created the company’s success that changing a winning team can sometimes be the only solution when seeking continued growth.

Trap 10: “Bystander apathy”

In this trap, people abdicate individual responsibility when they are in a crowd. Sometimes it is the apathy that stops anyone in a large crowd stopping a mugging; sometimes it is abdicating individual judgement to the perceived wisdom of the crowd. It seems that the risk of taking the contrarian path and being wrong is worse than being the anonymous lemming going over the cliff with all the others.

We see this in the various fads and booms that we fail to understand but cannot afford to miss out on. The recent “arbitrage” profits experienced in the world of private equity from ever growing P/E ratios is an example. Every Investment Director we spoke to when we surveyed them about this in 2006 knew that the P/E growth would need to stop at some stage, and admitted to stretching beyond managements’ business plans to make the investment case for purchase. But no-one felt they could afford not to keep investing. Everyone could see problems coming, and knew what would happen if they were left holding the baby when P/Es inevitably started shrinking, but to stop investing was to step out of the game.

There are numerous other cognitive traps, such as contamination effects from irrelevant data and scope neglect where we don’t minimise harm; but you probably already get the drift – people aren’t as rational as they think they are and they make irrational and potentially harmful decisions without realising it.

In our fourth and final post in this series, we suggest two ways of combating these cognitive traps, used for years in science and sport, in an attempt to throw some good sense and rationality back into the mix.


Copyright Latitude 2009. All rights reserved.

Latitude Partners Ltd
19 Bulstrode Street, London W1U 2JN
www.latitude.co.uk

For the full text of this series email steve@latitude.co.uk