VideoDeceptions. The strategic decisions that companies make result from interactions among their executives: a manager proposes an investment, for example, and an executive committee reviews and evaluates it. In this kind of setting, a conflict of interest often arises between an "agent" (in this case, the manager) and the "principal" (the corporation) on whose behalf the agent acts. Such "agency problems," which occur when the agent's incentives aren't perfectly aligned with the principal's interests, can lead to more or less intentional deceptions — misleading information provided to others — that compound the problem of the agent's unintentional distortions. Recall the CEO who was grappling with the big merger decision: trusting the protégé (the head of the largest division) exposed the CEO to the risk that the merger's proponent was not only overoptimistic but also attempting to further his own career by exaggerating the deal's upside or underestimating its risks.
When companies evaluate strategic decisions, three conditions frequently create agency problems. One is the misalignment of time horizons between individuals and corporations. Several consumer goods companies, for example, have noted that brand managers who rotate quickly in and out of their jobs tend to favor initiatives (such as introducing new product variants) with a short-term payback. These managers' deception, intentional or not, is to advance only certain projects — those aligned with their interests. The development of radically new products or other important projects with longer payback times can rarely succeed without a senior sponsor who is likely to be around longer.
Another problem that can generate harmful deceptions is the differing risk profiles of individuals and organizations. Consider a real-life example. A midlevel executive at a large manufacturing company decided not to propose a capital investment that had a 50-50 chance of either losing the entire $2 million investment or returning $10 million. Despite his natural loss aversion, the chance of a 5:1 gain should have enticed him into accepting the bet, and his superiors, for the same reasons, would have deemed it attractive. Instead, he worried that if the investment failed, his reputation and career prospects would take a blow, though he didn't anticipate being punished if the investment was forgone. As a result, he decided not to recommend it and thus in effect acted deceptively by not promoting an attractive investment. This asymmetry between results based on action and inaction is called the "omission bias," and here it magnified the executive's loss aversion.
The final agency issue arises from the likelihood that a subordinate knows much more than a superior does about a given issue. Higher-ranking executives must therefore make judgments about not just the merits of a proposal but also their trust in the person advancing it. This is unavoidable and usually acceptable: after all, what more important decision do CEOs make than choosing their closest associates? The tendency, however, is to rely too much on signals based on a person's reputation when they are least likely to be predictive: novel, uncertain environments such as that of the multinational that went ahead with the megamerger. We call the tendency to place too much weight on a person's reputation — and thus increase the exposure to deception — the "champion bias."
Furthermore, the multinational's merger decision exhibited an element of "sunflower management": the inclination of people in organizations to align themselves with the leader's real or assumed viewpoint. The CEO had expected to find dissenting voices among his senior executives. But except for the CFO, they believed that the CEO favored the deal and that the merger would proceed no matter what they said and thus kept their doubts to themselves for fear of harming their careers. In effect, they misled the CEO by suppressing what they really thought about the deal.
Improving Individual Decisions
Knowing that human nature may lead decision making astray, wise executives can use this insight to fortify their judgment when they make important decisions. To do so, however, they must know which bias is most likely to affect the decision at hand. Exhibit 2 offers a road map for the types of decisions where overoptimism or excessive risk aversion will probably be the determining factor.
In general, the key to reducing overoptimism is to improve the learning environment by generating frequent, rapid, and unambiguous feedback. In the absence of such an environment — for instance, when companies face rare and unusual decisions, which, unfortunately, are the most important ones — there is a bias toward optimistic judgments of the odds. The size of a decision determines the appropriate degree of risk aversion. For major ones, a certain amount of it makes sense — nobody wants to bet the farm. For smaller ones, it doesn't, though it often prevails for reasons we'll soon explore. Companies should see minor decisions as part of a long-term, diversified (and thus risk-mitigating) strategy.
As Exhibit 2 shows, companies don't always rationally factor risk into their decisions. In the large, infrequent ones (for instance, the industry-transforming merger that went horribly wrong) represented in the exhibit's upper-left quadrant there is a tendency to take an overly optimistic view. In essence, faulty judgments lead executives to take risks they would have avoided if they had had an accurate judgment of the odds. Since executives facing such a rare decision can't benefit from their own experience, they should learn from the experience of other companies by collecting case studies of similar decisions to provide a class of reference cases for comparison.
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