Most companies do things they are not proud of. At the financial level, they make irrational and biased decisions; they do not have a proper grip on risk; they miss opportunities, and they usually do not learn from their mistakes. Needless to say, companies do not widely publicise decisions that have resulted in failure.
It would be interesting if they did. Then investment analysts and commentators, instead of viewing companies as well-oiled money-making machines that are profitable whatever the market conditions and always able to improve on last year's performance, might have a more realistic view of company behaviour. Most commentators try to avoid thinking about the human and psychological frailties of companies, despite the fact that these frailties often have a drastic effect on company balance sheets.
The performance of many companies (especially newly created companies) depends to a large extent on two things - the calibre of the senior management team and the quality of their decision-making. Clearly the ideal scenario is to have a high calibre senior management team that recruits, strategically places, and retains experienced and skilled managers in those parts of the business where they can add most value. In addition to this, a consistent value-led decision-making process is needed, where good decisions, rather than necessarily good outcomes, are fostered and rewarded. Few companies manage themselves in this way.
A pharmaceutical company, if it spends enough on R&D, will eventually come up with a blockbuster drug. However, the cost of such R&D rises dramatically, often as a result of biased estimates of the success of candidate compounds, irrational 'beauty-contest'-based decision-making, and risk aversion arising as a function of considering candidate compounds as single projects rather than as part of a portfolio.
Energy exploration companies will find exploration costs spiralling out of control where they underestimate the country risk of a new drilling programme, or select which wells to drill as a function of the loudness of the voices of their geologists, who are likely to be constantly seeking the 'big one' rather than concentrating on the type of exploration that will provide the company's bread and butter.
In the same way, the irrational herd-mentality of investing in fashionable stocks often leads to dramatic underperformance of investment portfolios (a prime example being the supreme overconfidence in dot com stocks, which, with the equally biased lens of hindsight, now seems so irrational to us). Indeed, bias and poor quality decision-making lie ready to pounce on every high risk, high reward decision ever taken.
These sorts of examples are lost on most investment analysts. In most cases analysts examine the market, the brand, the competition and the senior management team in great detail. However, they rarely assess in any meaningful way the quality of decisions that have been made in the past and the processes in place to ensure consistent, value-maximising decision-making. They are as happy to decry a poor balance-sheet as to celebrate a good one, but they do not distinguish whether the latter was a result of good luck or of good decision-making.
Analysing decision-making
There is a huge amount of largely untapped research on decision-making, which could prove useful when trying to assess the big decisions made by large multinationals (let alone the multi-layered decision making that usually runs rampant through the various layers of middle management).
Some companies are beginning to analyse how they make large and small decisions and are calling in specialists with a rather different skills set. For example, in our own organisations - ORRA (an Oxford University-based start-up company) and environmental consultancy firm ERM - the academic specialists who analyse corporate decision-making come from an unusual range of backgrounds. They include psychologists, management consultants, mathematicians, sociologists and animal behaviour scientists (research on everything from sea slugs to primates can be of use when it comes to understanding how complex investment decisions are made).
We have found that the analysis of decision-making processes, the values associated with those decisions, and the business performance in which they result, is not often done in a formal way inside even blue chip companies and is rarely assessed in a consistent and quantitative way outside companies.
Organisations are generally too busy drowning to learn to swim; on they go, hoping that their decisions yield value rather than ensuring that they do.
And hope we might. Daniel Kahneman, a Princeton University psychologist, was awarded last year's Nobel Prize in Economics for showing how poor humans are at making decisions, and how our choices frequently fail to maximise value. The work of Kahneman and others and the burgeoning field of behavioural economics consign to history the classical (and highly optimistic) view of the individual and his company as perfectly rational, all-knowing, utility-maximising machines. In hindsight, we may think we hardly needed a psychologist to tell us just how fallible we are; the corporate battlefield is littered with the remains of irrational and biased decisions, and the companies which hosted them.
And if we think that hard quantitative or financial data gives us complete insight as to which companies and markets are on course to keel over, or where disaster may be lurking, we are wrong. For all the millions invested by fund managers, banks, and other financial institutions, our psychological overconfidence frequently causes us to be caught unawares when a stockmarket crash occurs.
Despite all the detailed engineering data and risk assessments available on the space shuttle, complacency resulted in disaster. If we had paid more attention to the quality of decision-making rather than the mere bottom line, might we have been a little more alert to the rogue juggernauts of Enron and Worldcom before they crashed in such spectacular style?
However, as long as the balance sheets do not raise too many eyebrows and the cracks can be glossed over, companies are often content to let their financial and marketing departments carry on with their business without too much probing into the quality of their decisions. The analysts are presented with the bottom line and occasionally with the company's filtered version of the events that led to it, and present their opinions on the basis of this incomplete, opaque, and biased information.
Paying attention to qualitative and psychological aspects of decision-making can improve the bottom line. Investment analysts will be better able to interpret financial results, and make more unbiased and predictive reports to the markets, by understanding more about the decision-making structures and skills that lead to that bottom line. We need to bring the psychology of decision-making and risk-taking out of academic journals and into the financial community and company boardrooms.
Dr Tom Woollard is partner, ERM corporate decision services, Tel: 020 7465 7273 E-mail: tom.woollard@erm.com, Dr Ed Mitchell is research fellow, Pembroke College Oxford, Tel: 01865 556 099, E-mail: ed.mitchell@pmb.ox.ac.uk
EHS decision-making
Environmental, health and safety reporting and sustainability reporting appear to be one of the few areas of business where major multinationals are happy to publicly communicate how badly they are doing. Their glossy reports detail fatalities, injuries, long-term illnesses in the workforce, regulatory fines, pollution incidents and how many employees were sacked last year for fraudulent behaviour. Some stakeholders now believe that performance in this area can be used as an indicator of management performance.
It seems almost certain that EHS programmes are as afflicted by irrationality, panic, and biased decision-making as the more traditional aspects of business.
An experiment by Kahneman and Amos Tversky presented two scenarios to experimental subjects concerning an outbreak of a fictional disease expected to kill 600 people without action.
In the first scenario, subjects chose between Programme A, which saves 200 lives for sure, or Programme B, which has a one third probability that all 600 people will be saved, but a two-thirds probability that no lives will be saved. They found that most went for 'the fixed option' - Programme A (in other words, the experimental subjects were risk averse).
In the second scenario, subjects could choose between Programme C, which would result in 400 people dying, and Programme D, which has a one-third probability that nobody will die and a two-thirds probability of all 600 people dying. Most opted for 'the risky option' - Programme D (the subjects were risk prone).
A cursory analysis shows that Programmes A and B are the exact equivalents of Programmes C and D. However, the way the scenarios are framed (lives saved versus lives lost) dramatically affects choice. Kahneman and Tversky, as a result of this and other experiments, formulated a description of choice called 'prospect theory'. The theory predicts (and is confirmed by the evidence) that we are risk averse when choosing between gains (lives saved in the above example), and risk prone when choosing between losses (ie lives lost).
Finance and marketing departments will tend to think in gains. They therefore tend towards being risk averse, missing risky opportunities simply due to their preference for 'the sure thing'. EHS departments, on the other hand, deal in losses; prospect theory predicts that they will tend to choose risky alternatives.
EHS corporate reports can give a unique insight into the calibre of the decision-making process in a company. They can tell you about its investment priorities, its ability to deal with liability issues, its willingness to invest in operations which fall below its usual standards of performance.
EHS reports can also can say much about a company's risk appetite, transparency, ability to communicate and manage complex issues, leadership and cross cultural sensitivity. In terms of understanding corporate decision-making quality, they may provide more relevant information than financial reports.
