Making Big Decisions: Don’t Let Your Brain Be The Flaw In The Thinking - Part II

Author: Christian Bamber
Posted: Monday 26th September, 2011. 09:58:49

This week we continue our examination of behavioural economics and how our brains can cause us to deviate from the path of rational decision-making. (Part I of this article can be found here). Roxburgh (2003) has already illustrated how overconfidence, mental accounting, the status quo bias, and anchoring can all have this effect and now we will look at the final four contributors.

Flaw 5: Throwing good money after bad

Also known as the sunk-cost effect, this can be frequently observed when larger-scale projects or investments overrun their original schedules and budgets. Consequently, their original economic case no longer holds true yet organisations will still continue to invest in them so that they are completed.

Senior decision-makers can fall into the sunk-cost trap often when they have personally championed a project or if an organisation has pinned much of its future success on a project coming to fruition. It can be extremely hard for individuals and organisations to face up to the reality that a project has no prospect of being completed successfully.

Why is throwing good money after bad so hard to avoid? One explanation takes us back to loss aversion: we would rather spend an extra Ł10,000 completing an unviable Ł100,000 project than write off the Ł100,000. Anchoring also offers another explanation: once we have anchored ourselves around a price tag of Ł100,000, another Ł10,000 doesn’t seem that much.

There are, however, several ways in which we can avoid the trap:

• For every additional chunk of investment required, ensure that the additional funds will return an equal (or greater) return to the project outcome.
• Be prepared to write-off projects early if the economics no longer stack up. This is all about portfolio management and successfully managing a portfolio entails jettisoning the losers. The quicker you get out, the less money you will lose and the easier it will be to make an exit.
• Introduce a “gated funding” system whereby a project must meet certain targets along the way before further funds are released.

The above applies whether you are a small practice rolling out a new service initiative or whether you might be a large corporate group of practices looking to build your 200th centre. In fact, the bigger players are more likely to fall foul of the sunk-cost effect due to the often relatively small size of extra funds required to complete a project compared with the initial investment.

Flaw 6: The herding instinct

The desire to conform with others is a fundamental human trait and the foundation of many psychological theories. Warren Buffett had this to say about it:

Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.

What he is saying here is that the only thing a senior-decision maker can do worse than making a huge strategic mistake is being the only person in the industry to make it.

Once again, the banking industry offers several classic examples of following the crowd, the most recent one being the subprime crisis. Lehman Brothers took the brunt of the bad press (quite rightly given the sums involved) but most of the “reputable” banks were dealing in subprime lending to some extent. Had it just been Lehman Brothers guilty of this, there would still be a dent in the economy but not to the extent of the current situation.

What does this tell us? It tells us that the best strategies break away from the trend. “Me-too” strategies are often the worse ones to adopt. Adopting best practice is often the worse practice: if we are all “the best” then no one will ever get ahead. Of course, some actions are necessary to match the competition but these actions will not be a unique source of competitive advantage.

It’s not easy to make the break away from the crowd. An innovative strategy may draw scepticism from industry experts and sometimes it will be justified. Remember, as long as you kill a failing strategy early, your losses will be limited. However, when the experts are wrong, your rewards will be great.

Flaw 7: Misestimating future hedonic states

What does this mean? In simple terms, that people are bad at estimating how much pleasure or pain they will feel if their circumstances change dramatically.

Social scientists have shown that when people undergo major change, their lives are typically neither as bad nor as good as they had expected. People adjust remarkably quickly and their level of pleasure (hedonic state) ends up just about where it was before.

The classic example of this at play is in the mergers and acquisitions field. Often, top management will resist any loss of independence and will want to hang on to the status quo. Frontline staff will often also resist a takeover or merger however frustrated they are with their existing management for fear of being worse off.

Although mergers and acquisitions are now rife amongst veterinary practices, there may be a much more practical application to misestimating future hedonic states. Change in general is all about us and yet for the most part we fear change.

When evaluating a strategy that will cause change (and they all will to some degree), consider that the effects on individuals in the long-term will not be quite as bad as may be anticipated. In other words, don’t let the inertia and pain of change stand in your way.

In the words of Field Marshall Slim, “in battle nothing is ever as good or as bad as the first reports of excited men would have it.” This is a good guide for all senior decision-makers trying to navigate the difficulties of change, with the inevitable swings in emotion and morale.

Flaw 8: False consensus

The false-consensus effect describes how people tend to overestimate the extent to which others share their views and experiences.

There are many known causes of this including:

• Confirmation bias – the tendency to seek out opinions and facts that support our own beliefs and hypotheses
• Selective recall – the desire to remember only facts and experiences that reinforce our assumptions
• Biased evaluation – quickly accepting any evidence that supports our hypotheses
• Groupthink – giving in to the pressure to agree with everyone else in a group

Here are some examples that I have encountered and you probably have at some point too:

• “The vets are 100 per cent behind this decision” – false consensus
• “The managers all agree with the new strategy” - groupthink
• “I’ve only heard good things about our customer service” – selective recall

The problem is that false consensus often leads senior decision-makers to overlook important threats to and issues with their actions. However, the dangers can be minimised in the following ways:

• Create a culture of (constructive) challenge – value open criticism and contrary views
• Establish a system of checks and balances to fully evaluate major decisions, particularly if they have a dominant personality behind them.
• Don’t “lead the witness.” Instead, try to refute a hypothesis or set up an opposing hypothesis to evaluate.

An awareness of the brain’s flaws and an understanding into behavioural economics can at least help us to go some way in avoiding biases in decision-making.

Of course, even if we could always remove theses from the equation, greed, arrogance, poor analysis and all the other corporate evils will still provide the world with plenty of cases of bad strategy. However, understanding some of the flaws in our thinking may help you to make better strategic decisions in your own enterprise.

Roxburgh, C., 2003. Hidden flaws in strategy. McKinsey Quarterly, May.

Christian Bamber is Principal Consultant and Director of Approach Strategy, a consulting firm specialising in strategy services to service industries and not-for-profit organisations. For more information, please contact Approach Strategy at christian@approachstrategy.co.uk. Tel: 01225 722 654 or visit their website www.approachstrategy.co.uk

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