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Wednesday, March 17, 2010

The case for behavioral strategy

Left unchecked, subconscious biases will undermine strategic decision making. Here’s how to counter them and improve corporate performance.

McKinsey Quarterly

MARCH 2010 • Dan Lovallo and Olivier Sibony

Source: Strategy Practice

Strategy, Strategic Thinking article,

In This Article

Once heretical, behavioral economics is now mainstream. …

Yet very few corporate strategists making important decisions consciously take into account the cognitive biases—systematic tendencies to deviate from rational calculations—revealed by behavioral economics. It’s easy to see why: … in strategic decision making leaders need to recognize their own biases. So despite growing awareness of behavioral economics and numerous efforts by management writers, … to make the case for its application, most executives have a justifiably difficult time knowing how to harness its power.1

This is not to say that executives think their strategic decisions are perfect. In a recent McKinsey Quarterly survey of 2,207 executives, only 28 percent said that the quality of strategic decisions in their companies was generally good, 60 percent thought that bad decisions were about as frequent as good ones, and the remaining 12 percent thought good decisions were altogether infrequent.2 … Mergers routinely fail to deliver the expected synergies.3 Strategic plans often ignore competitive responses.4 And large investment projects are over budget and over time—over and over again.5

In this article, we share the results of new research quantifying the financial benefits of processes that “debias” strategic decisions. …

The value of good decision processes

Think of a large business decision your company made recently… . Three things went into it. The decision … involved some fact gathering and analysis. It relied on the insights and judgment of … executives (a number sometimes as small as one). And it was reached after a process … turned the data and judgment into a decision.

Our research indicates that, … good analysis in the hands of managers who have good judgment won’t naturally yield good decisions. …[The] process—is also crucial. …

We asked managers to report on the extent to which they had applied 17 practices in making that decision. Eight of these practices had to do with the quantity and detail of the analysis: … The others described the decision-making process: … We chose these process characteristics because in academic research and in our experience, they have proved effective at overcoming biases.6

After controlling for factors like industry, geography, and company size, we used regression analysis to calculate how much of the variance in decision outcomes7 was explained by the quality of the process and how much by the quantity and detail of the analysis. The answer: process mattered more than analysis—by a factor of six. This finding does not mean that analysis is unimportant, as a closer look at the data reveals: almost no decisions in our sample made through a very strong process were backed by very poor analysis. … The reverse is not true; superb analysis is useless unless the decision process gives it a fair hearing.

To get a sense of the value at stake, we also assessed the return on investment (ROI) of decisions characterized by a superior process.8 The analysis revealed that raising a company’s game from the bottom to the top quartile on the decision-making process improved its ROI by 6.9 percentage points. …

The building blocks of behavioral strategy

Any seasoned executive will of course recognize some biases and take them into account. That is what we do when we apply a discount factor to a plan from a direct report (correcting for that person’s overoptimism). That is also what we do when we fear that one person’s recommendation may be colored by self-interest and ask a neutral third party for an independent opinion.

However, academic research and empirical observation suggest that these corrections are too inexact and limited to be helpful. … [Fundamentally'], biases are pervasive because they are a product of human nature—hardwired and highly resistant to feedback, however brutal. For example, drivers laid up in hospitals for traffic accidents they themselves caused overestimate their driving abilities just as much as the rest of us do.9

Improving strategic decision making therefore requires not only trying to limit our own (and others’) biases but also orchestrating a decision-making process that will confront different biases and limit their impact. …

Building such a process for strategic decision making requires an understanding of the biases the process needs to address. In the discussion that follows, we focus on the subset of biases we have found to be most relevant for executives and classify those biases into five simple, business-oriented groupings … . [As] the psychologist and Nobel laureate in economics Daniel Kahneman has pointed out, the odds of defeating biases in a group setting rise when discussion of them is widespread. …[We] also provide some general principles and specific examples of practices that can help counteract it.

How cognitive biases affect strategic decision making

Explore the biases most pertinent to business and the ways they can combine to create dysfunctional patterns in corporate cultures.

Launch Interactive

Counter pattern-recognition biases by changing the angle of vision

… Common pattern-recognition biases include saliency biases (which lead us to overweight recent or highly memorable events) and the confirmation bias (the tendency, once a hypothesis has been formed, to ignore evidence that would disprove it). Particularly imperiled are senior executives, whose deep experience boosts the odds that they will rely on analogies, from their own experience, that may turn out to be misleading.10

Pattern recognition is second nature to all of us—and often quite valuable—so fighting biases associated with it is challenging. The best we can do is to change the angle of vision by encouraging participants to see facts in a different light and to test alternative hypotheses to explain those facts. …

Sometimes, simply coaxing managers to articulate the experiences influencing them is valuable. According to Kleiner Perkins partner Randy Komisar, for example, a contentious discussion over manufacturing strategy at the start-up WebTV11 suddenly became much more manageable once it was clear that the preferences of executives about which strategy to pursue stemmed from their previous career experience. When that realization came, he told us, there was immediately a “sense of exhaling in the room.” Managers with software experience were frightened about building hardware; managers with hardware experience were afraid of ceding control to contract manufacturers.

Getting these experiences into the open helped WebTV’s management team become aware of the pattern recognition they triggered and see more clearly the pros and cons of both options. Ultimately, WebTV’s executives decided both to outsource hardware production to large electronics makers and, heeding the worries of executives with hardware experience, to establish a manufacturing line in Mexico as a backup, in case the contractors did not deliver in time for the Christmas season. That in fact happened, and the backup plan, which would not have existed without a decision process that changed the angle of vision, “saved the company.”

Another useful means of changing the angle of vision is to make it wider by creating a reasonably large—in our experience at least six—set of similar endeavors for comparative analysis. For example, in an effort to improve US military effectiveness in Iraq in 2004, Colonel Kalev Sepp—by himself, in 36 hours—developed a reference class of 53 similar counterinsurgency conflicts, complete with strategies and outcomes. This effort informed subsequent policy changes.12

Counter action-oriented biases by recognizing uncertainty

Most executives rightly feel a need to take action. However, the actions we take are often prompted by excessive optimism about the future and especially about our own ability to influence it. …When you or your people feel—especially under pressure—an urge to take action and an attractive plan presents itself, chances are good that some elements of overconfidence have tainted it.

To make matters worse, the culture of many organizations suppresses uncertainty and rewards behavior that ignores it. For instance, in most organizations, an executive who projects great confidence in a plan is more likely to get it approved than one who lays out all the risks and uncertainties surrounding it. …

Superior decision-making processes counteract action-oriented biases by promoting the recognition of uncertainty. For example, it often helps to make a clear and explicit distinction between decision meetings, … and implementation meetings… . Also valuable are tools—such as scenario planning, decision trees, and the “premortem” … that force consideration of many potential outcomes. And at the time of a major decision, it’s critical to discuss which metrics need to be monitored to highlight necessary course corrections quickly.

Counter stability biases by shaking things up

In contrast to action biases, stability biases make us less prone to depart from the status quo than we should be. This category includes anchoring—the powerful impact an initial idea or number has on the subsequent strategic conversation. … Stability biases also include loss aversion … and the sunk-cost fallacy, which can lead companies to hold on to businesses they should divest.13

One way of diagnosing your company’s susceptibility to stability biases is to compare decisions over time. For example, try mapping the percentage of total new investment each division of the company receives year after year. If that percentage is stable but the divisions’ growth opportunities are not, this finding is cause for concern…. …[There] is a near-perfect correlation between a business unit’s current share of the capital expenditure budget and its budget share in the previous year. …

One way to help managers shake things up is to establish stretch targets that are impossible to achieve through “business as usual.” … Finally, challenging budget allocations at a more granular level can help companies reprioritize their investments.14

Counter interest biases by making them explicit

Misaligned incentives are a major source of bias. “Silo thinking,” in which organizational units defend their own interests, is its most easily detectable manifestation. …

The truth is that adopting a sufficiently broad (and realistic) definition of “interests,” including reputation, career options, and individual preferences, leads to the inescapable conclusion that there will always be conflicts … . Strong decision-making processes explicitly account for diverging interests. For example, if before the time of a decision, strategists formulate precisely the criteria that will and won’t be used to evaluate it, they make it more difficult for individual managers to change the terms of the debate to make their preferred actions seem more attractive. …

Counter social biases by depersonalizing debate

… Even when nothing is at stake, we tend to conform to the dominant views of the group we belong to (and of its leader).15 … An absence of dissent is a strong warning sign. Social biases also are likely to prevail in discussions where everyone in the room knows the views of the ultimate decision maker (and assumes that the leader is unlikely to change her mind).

Countless techniques exist to stimulate debate among executive teams, and many are simple to learn and practice. … Genuine debate requires diversity in the backgrounds and personalities of the decision makers, a climate of trust, and a culture in which discussions are depersonalized.

Populating meetings or teams with participants whose interests clash can reduce the likelihood that one set of interests will undermine thoughtful decision making

Most crucially, debate calls for senior leaders who genuinely believe in the collective intelligence of a high-caliber management team. Such executives see themselves serving not only as the ultimate decision makers but also as the orchestrators of disciplined decision processes. …

Four steps to adopting behavioral strategy

… Leaders who want to shape the decision-making style of their companies must commit themselves to a new path.

1. Decide which decisions warrant the effort

Some executives fear that applying the principles we describe here could be divisive, counterproductive, or simply too time consuming … We … do not suggest applying these principles to all decisions. …[Companies] can and should pay special attention to two types of decisions.

The first set consists of rare, one-of-a-kind strategic decisions. Major mergers and acquisitions, “bet the company” investments, and crucial technological choices fall in this category. … The second set includes repetitive but high-stakes decisions that shape a company’s strategy over time. … Formal processes—often affected by biases—are typically in place to make these decisions.

2. Identify the biases most likely to affect critical decisions

Open discussion of the biases that may be undermining decision making is invaluable. …

3. Select practices and tools to counter the most relevant biases

Companies should select mechanisms that are appropriate to the type of decision at hand, to their culture, and to the decision-making styles of their leaders. …

If, … you have already thought of three reasons these techniques won’t work in your own company’s culture, you are probably right. … Adopting behavioral strategy means not only embracing the broad principles set forth above but also selecting and tailoring specific debiasing practices to turn the principles into action.

4
. Embed practices in formal processes

By embedding these practices in formal corporate operating procedures (such as capital-investment approval processes or R&D reviews), executives can ensure that such techniques are used with some regularity and not just when the ultimate decision maker feels unusually uncertain about which call to make. …

The behavioral-strategy journey requires effort and the commitment of senior leadership, but the payoff—better decisions, not to mention more engaged managers—makes it one of the most valuable strategic investments organizations can make.

About the Authors

Dan Lovallo is a professor at the University of Sydney, a senior research fellow at the Institute for Business Innovation at the University of California, Berkeley, and an adviser to McKinsey; Olivier Sibony is a director in McKinsey’s Brussels office.

Notes

1 See Charles Roxburgh, “Hidden flaws in strategy,” mckinseyquarterly.com, May 2003; and Dan P. Lovallo and Olivier Sibony, “Distortions and deceptions in strategic decisions,” mckinseyquarterly.com, February 2006.

2 See “Flaws in strategic decision making: McKinsey Global Survey Results,” mckinseyquarterly.com, January 2009.

3 See Dan Lovallo, Patrick Viguerie, Robert Uhlaner, and John Horn, “Deals without delusions,” Harvard Business Review, December 2007, Volume 85, Number 12, pp. 92–99.

4 See John T. Horn, Dan P. Lovallo, and S. Patrick Viguerie, “Beating the odds in market entry,” mckinseyquarterly.com, November 2005.

5 See Bent Flyvbjerg, Dan Lovallo, and Massimo Garbuio, “Delusion and deception in large infrastructure projects,” California Management Review, 2009, Volume 52, Number 1, pp. 170–93.

6 Research like this is challenging because of what International Institute for Management Development (IMD) professor Phil Rosenzweig calls the “halo effect”: the tendency of people to believe that when their companies are successful or a decision turns out well, their actions were important contributors (see Phil Rosenzweig, “The halo effect, and other managerial delusions,” mckinseyquarterly.com, February 2007). We sought to mitigate the halo effect by asking respondents to focus on a typical decision process in their companies and to list several decisions before landing on one for detailed questioning. Next, we asked analytical and process questions about the specific decision for the bulk of the survey. Finally, at the very end of it, we asked about performance metrics.

7 We asked respondents to assess outcomes along four dimensions: revenue, profitability, market share, and productivity.

8 This analysis covers the subset of 673 (out of all 1,048) decisions for which ROI data were available.

9 Caroline E. Preston and Stanley Harris, “Psychology of drivers in traffic accidents,” Journal of Applied Psychology, 1965, Volume 49, Number 4, pp. 284–88.

10 For more on misleading experiences, see Sydney Finkelstein, Jo Whitehead, and Andrew Campbell, Think Again: Why Good Leaders Make Bad Decisions and How to Keep It from Happening to You, Boston: Harvard Business Press, 2008.

11 WebTV is now MSN TV.

12 Thomas E. Ricks, Fiasco: The American Military Adventure in Iraq, New York: Penguin Press, 2006, pp. 393–94.

13 See John T. Horn, Dan P. Lovallo, and S. Patrick Viguerie, “Learning to let go: Making better exit decisions,” mckinseyquarterly.com, May 2006.

14 For more on reviewing the growth opportunities available across different micromarkets ranging in size from $50 million to $200 million, rather than across business units as a whole, see Mehrdad Baghai, Sven Smit, and Patrick Viguerie, “Is your growth strategy flying blind?” Harvard Business Review, May 2009, Volume 87, Number 5, pp. 86–96.

15 The Asch conformity experiments, conducted during the 1950s, are a classic example of this dynamic. In the experiments, individuals gave clearly incorrect answers to simple questions after confederates of the experimenter gave the same incorrect answers aloud. See Solomon E. Asch, “Opinions and social pressure,” Scientific American, 1955, Volume 193, Number 5, pp. 31–35.