VideoConversely, excessive risk aversion is usually the dominant bias in the small but common decisions shown in the exhibit's lower-right quadrant: good learning environments temper optimism, and the human reluctance to bet — unless the potential gains are much bigger than the losses — comes to the fore. A key factor in such cases is the tendency of companies not to see individual projects within a stream or pool of similar undertakings. If companies did so, they would move closer to risk neutrality. Instead they tend to evaluate projects in isolation, which leads them to emphasize a single project's outcome and thus to fear the losses.
A complicating factor, as we have already noted, is the possibility that the decision maker expects to be blamed if an investment fails and thus has a more risk-averse attitude than might be rational for a company, which can pool comparable investments into an attractive risk-mitigating portfolio. Senior executives sometimes fail to compensate for this bias, as they could by encouraging a higher degree of risk taking in minor decisions, which are often made in lower levels of the corporate hierarchy.
The remaining two cases in the exhibit are relatively unproblematic. In large, frequent decisions — for example, a private equity firm's deliberations about a new investment or the construction of a new plant using existing technology — a significant degree of risk aversion is sensible and the frequency of the endeavors offers ample learning opportunities. In small, rare decisions optimism and loss aversion may counteract each other, and by definition this class of decision is comparatively unimportant.
Engineering Better Decision Making
Organizations don't all suffer equally from distortions and deceptions; some are better at using tools and techniques to limit their impact and at creating a culture of constructive debate and healthy decision making. Corporate leaders can improve an organization's decision-making ability by identifying the prevalent biases and using the relevant tools to shape a productive decision-making culture.
Identifying the problems. Corporate leaders should first consider which decisions are truly strategic, as well as when and where they are made. Applying process safeguards to key meetings in formal strategic-planning exercises is tempting but not necessarily appropriate. Often the real strategic decision making takes place in other forums, such as R&D committees or brand reviews.
After targeting the crucial decision-making processes, executives should examine them with two goals in mind: determining the company's exposure to human error and pinpointing the real problems. A decision-making safeguard that is useful in one setting could be counterproductive in another — say, because it reinforces a high level of risk aversion by enforcing hard targets for new projects. An objective analysis of past decisions can be a first step: does the company often make overoptimistic projections, for example?
Tools against distortions and deceptions. Once companies undertake this diagnostic process, they can introduce tools that limit the risk of distortions and deceptions. One way of tempering optimism is to track the expectations of individuals against actual outcomes in order to examine the processes (such as sales forecasts) that underlie strategic decisions. Companies should review these processes if forecasts and results differ significantly. They can also provide feedback where necessary and show clearly that they remember forecasts, reward realism, and frown on overoptimism.
An objective analysis of past decisions can be a first step: for example, does the company make many overoptimistic projections?
A more resource-intensive way of avoiding overoptimistic decisions is to supplement an initial assessment with an independent second opinion. Many companies try to do so by assigning important decisions to committees — for instance, the investment committees of investment firms. If the members have the time and willingness to challenge proposals this approach is effective, but committees depend on the facts brought before them. Some private equity firms address that problem by systematically taking a fresh look: after a partner has supervised a company for a few years, a different partner evaluates it anew. A fresh pair of eyes with no emotional connections can sometimes see things that escape the notice of more knowledgeable colleagues.
Loss aversion, magnified by career-motivated self-censorship of "risky" proposals, has its roots in explicit and implicit organizational incentives. Lower-level managers typically encounter more but smaller risks, so organizations can embed a higher tolerance for them in certain systems — for instance, by using different criteria for the financial analysis of larger and smaller projects.
Financial incentives also can be used to counter distortions and related principal-agent problems. Many companies, for example, find that operating-unit managers tend to optimize short-term performance at the expense of long-term corporate health, partly because their compensation is tied to the former and partly because they might well have moved on by the time long-term decisions bear fruit. Some companies address this problem through "balanced scorecards" that take both dimensions into account. Others tie compensation to the performance of an executive's current and previous business units.
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