General George Patton said that, and I am a true believer. Decisions are the life-blood of a thriving business, whether it be deciding which markets to enter or exit, which businesses to buy or sell, how to distribute capital, or the best way to foster innovation. In a world defined by the ‘move fast and break things’ mentality, making shrewd decisions and making them quickly are the ultimate determinants of success.
The essence of a good decision lies in the mind of the decision maker. Yet we all know that the human brain, while an extraordinary marvel, is far from perfection. We rely on two key hard-wired processes inside our minds for decision-making: pattern recognition and emotional impressions, which are commonly bundled as “heuristics”. Scientists around the world have spent a good part of the last century uncovering the mystery of heuristics, and how they help us navigate the inherent complexity of the world around us. Heuristics could be thought of as a series of mental shortcuts that the brain uses to make a large number of decisions, very quickly. For example, one heuristic associates clarity with proximity. The clearer an object appears, the closer it must be. Conversely, the fuzzier an object, the further we assume it to be. These shortcuts work just fine in most cases. The key word here is ‘most’. Heuristics are not foolproof. On a hazy day, our eyes might trick us into thinking that an object is further away than it actually is. This flaw might not be such an issue if you are walking down a footpath. For an aircraft pilot on the other hand, this might be catastrophic. A similar class of heuristics comes into play when executives are charged with making critical decisions that have a direct effect on the lives of many people.
Many studies have shown that, for most people, the number cited in the first question would significantly influence the response to the second question. When the number in the first question is doubled to $60 billion, the responses to the second question subsequently rise by many billions of dollars. What this experiment demonstrates is the phenomenon of “anchoring”: our brains have a natural tendency to place greater value on the first pieces of information we receive. We then frame all subsequent judgements and decisions under the influence of this initial input. What can we do about it? Simply being aware of this phenomenon can help us to overcome the dangers this heuristic presents. It always helps to tackle a problem on your own before consulting others and being anchored by their train of thought.
Making assumptions of uncertain events is the crux of a manager’s existence. They need to continually predict movements of commodity prices, interest rate risks, stock market movements and product demand, to name just a few. The logical short circuits we’ve discussed so far can greatly influence how we confront these uncertainties. Yet, there is another class of heuristics that comes into play when we try to deal with ambiguity.
Most of us have a natural tendency to make a prediction of future events based on memories of what happened in the past. As a result, dramatic or heavily publicized events tend to leave a strong impression on our minds, distorting our probability assessments. Take aircrafts, for example. Plane crashes tend to get disproportionate attention in public media due to their horrific nature, causing people to overestimate the probability of a plane crash. Yet, statistically speaking, it is safer to catch a plane half way across the world than it is to drive a car down the road. Similarly, corporate lawyers often get caught in the same heuristic trap during liability suits. Colossal damage awards are heavily publicised in media while far more common trial outcomes often go ignored. Consequentially, lawyers overestimate the potential magnitude of a plaintiff’s compensation, leading to larger than necessary out-of-court settlements.
Major strategic decisions, like which market to enter or exit, which business to buy or sell and how to distribute capital or talent can loose their way in the vast forests of bureaucracy within large multi-nationals. This is an intrinsic characteristic of most burgeoning businesses: the greater the level of complexity in business operations, the more governance is needed to keep all process in check. So how can companies continue to react with speed and consistency in a continuously evolving market?
Paul Rogers and Marcia Blenko, partners with Bain and Company, pondered this very question during the course of their consultancy careers. They proposed that decisions usually get stalled at various structural bottlenecks within a company: for example, with the rise of outsourcing, mergers and joint ventures, companies need to clearly understand which decisions are owned by external partners and which decisions are of concern to the company itself. In the case of outsourcing, apparel and footwear firms like Nike used to assume that foreign suppliers could be responsible for decisions about factory working conditions and employee wages. We all know where that went.
Another type of bottleneck occurs with cross-function decisions, where, for example, manufacturers must play a balancing act between product development and marketing. At a major British department store chain, John Lewis, company buyers wanted to increase sales and reduce complexity by offering fewer salt and pepper mill models. But the company launched the refined product strategy without involving the sales staff. The result? Sales fell. Within the stores, salespeople, not understanding their managers’ strategy, had halved shelf space in correlation with the reduction in product range, rather than maintaining the same space and stock more products.
But I hear you ask, how could any of this be relevant to the world of investment and financing? The key here is to understand that when analysts on Wall Street make their recommendations on company stock, they get down into the nitty-gritty of exactly what is happening within a business. They talk to the C-suite executives, the division managers, they tour factories and they analyse all critical product innovations. Bad attention from the press about factory conditions in third world countries, or a product refinement strategy gone wrong, can, and usually does, affect the bottom line profitability of corporations, and in turn, shareholding investors. Being keenly aware of the scope and power of decision-making strategies can help you become, even just a little bit more of a savvy investor.