Facing Up to the Demographic Dilemma

At the World Economic Forum’s summer meeting in Dalian, China, four experts discussed the challenges and opportunities that aging populations present to business.

strategy+business magazine

with Yoshito Hori, Jean-Pierre Lehmann, Timothy Ma Kam Wah, and Vanessa Wang

The world is in the midst of an epochal demographic shift that will reshape societies, economies, and markets over the next century. The big news is that the world population, according to United Nations forecasts, will either stabilize or peak around 2050, after growing for centuries at an ever-accelerating rate. The main reason is the decline occurring in birthrates as nations advance economically, and it is already having a significant impact: As birthrates drop and better health care prolongs life spans, the world’s population is aging rapidly. For example, between 1950 and 2000, the percentage of the world population older than 60 rose almost imperceptibly to 10 percent from 8 percent. By 2050, however, that percentage will more than double, to 21 percent. And in many countries — notably Japan and those in western Europe — the share of population age 60-plus will be more than 40 percent by mid-century.

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The demographic dynamics in the developing world are radically different. Birthrates are still high, and populations are both growing and becoming younger. Over the next few decades, many of these countries will experience what David Bloom, chair of the department of global health and population at Harvard’s School of Public Health, has called a “demographic dividend”: a rising proportion of young people entering the workforce, driving productivity and economic growth. (See “India’s Demographic Moment,” by Nandan Nilekani, s+b, Autumn 2009.)

There are also anomalies among nations. In the developed world, the United States has many of the same demographic attributes as Japan and Europe, but high rates of immigration are offsetting the trend toward aging. In the developing world, the population of China is destined to begin aging rapidly as the result of the government’s past policies to limit population growth. …

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These demographic shifts will drive massive change in markets and economies, and will require entirely new approaches on the part of both policymakers and business leaders. But the shifts seem to get less attention than they deserve — largely because they take place over time spans much longer than the political and business cycles that drive most legislative and managerial agendas. To identify some of the most significant challenges that will need to be addressed as populations age, strategy+business teamed with the World Economic Forum to convene a roundtable of notable thought leaders with expertise in Asia….

The discussion was moderated by s+b Executive Editor Rob Norton and took place on September 12, 2009, at the World Economic Forum’s third Annual Meeting of the New Champions in Dalian, China.

S+B: What would you consider the most significant challenge that political and business leaders face related to aging populations?

HORI: We’re seeing a very big generation gap opening up, between the older people who are enjoying government benefits and the younger generations that are bearing the financial burden. … But people are not aware enough of what’s going to happen in 10 or 15 years’ time. … Is the priority of the country to care for the elderly or to look to younger generations for innovation? …

LEHMANN: One of the things unique to the period that we’re living in now is that we must think in terms of centuries rather than decades. … When I look at my grandchildren, I realize that they will be around in 2100.

One of the things that concerns me about aging populations is that older people — to make a big generalization — tend to be more self-centered. In Europe, for example, the politics are very short-term, and that’s because politicians know that old-age pensioners vote and have money, whereas young people don’t vote, and in any case don’t have much money. …

MA: I am concerned that governments, businesses, and people in general are not well prepared to think about the implications of aging societies. I attended the first United Nations Assembly on Ageing in Vienna, in 1982. … But 20 years later, at the U.N.’s Second Assembly on Ageing in Madrid, in 2002, the same topics were brought up again, and since then they keep being repeated. …[The] preparation has still not been done. I feel that we all are not well prepared, not only physically, but psychologically, morally, and spiritually.

WANG: …I feel the demographic issues today are where climate issues were five or 10 years ago. Everybody had heard about it, but nobody cared. …[If] it doesn’t feel like an opportunity, there’s no urgency. As Mr. Ma said, the topics keep repeating and repeating, but everybody still says we are not ready to address them.

So my thought is that we have to bring focus to this issue — the need for changes in social policy and for innovation in products and services. There is a huge gap in information. … Better information is the fundamental thing needed to address the demographic risks that we have been discussing over the last few years.

MA: … In most of society, we define … aging as regression, as poor, as noncontributive, as reliance and dependency. I think we need to appeal to the whole world to position aging as a blessing to society, not a problem or a difficulty. …

LEHMANN: …I don’t think that we can say that aging is only a blessing for society. I think it can also be a terrible drain … [In] some cases it can be a curse. …

MA: I think we also need to focus on those 90 percent [of elders] who are healthy and active, and can live independently and still contribute to their families and to society. It seems that we always misallocate our attention to those who are weak and senile and sick.

HORI: We all pay respect to the elderly, and we want them to live longer and have a happy life and a happy ending as well; … But as the number of elderly people rises in proportion to the number of young people, the question is, Who is going to bear the burden? … the implications for business and society….

WANG: Again, I think that there is a lack of focus and a lack of data that’s tailored toward solving problems. …When we get the kind of information that can show how we can create efficiencies in medicine that could help solve problems related to aging, then people will start to see business opportunities instead of problems. …

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S+B: As we turn to potential solutions to some of the problems posed by population aging, are there approaches from business that could be helpful?

LEHMANN: … One obvious solution that would be beneficial for both Japan and Europe as they try to deal with aging populations would be to open up the frontiers to migration and allow in younger workers from less-developed countries. Another idea is to encourage elderly people to live elsewhere …You say, “Look, the bad news is that we have to reduce your pension. The good news is we’re moving you to Libya, where the standard of living is much lower and your pension will go a much longer way.”

HORI: I don’t think those policies are politically practical, and they won’t solve the problem.

LEHMANN: They are certainly not a major part of the solution, but they are ideas that could help, and there may be ways to make them attractive to people. I think the globalization of aging is one of the options that should be explored, even if some of the solutions are difficult or unacceptable for political or other reasons.

MA: One of the problems with focusing on solutions is that as policymakers and businesspeople think about community resources and corporate commercial resources, they currently don’t see the potential market power of the aging population. But when a quarter of the total population in the world is aging, they cannot disregard that. Those people have to be accommodated. …

WANG: It’s interesting to think of what the “silver” GDP will be in the future. The more we can quantify the consumption of the elderly, the better we can gain an appreciation of the business they generate, and think of the steps that will stimulate this silver market.

HORI: The Japanese government is taking steps to address these challenges. The new government, … will introduce a US$260 allowance per child per month to encourage larger families. Additional child-care services will also be implemented. Although that does not provide a short-term solution or a midterm solution, it will help over time. … Other partial solutions may include encouraging more women to join the workforce, extending retirement ages, and, as we discussed, encouraging countries to welcome foreign workers.

But when you look at specific issues like our pension system, eventually elderly people are going to have to accept the fact that they will get their pensions later, and those pensions will be smaller. …

S+B: What about the skills gaps that we see opening in the developed countries where the aging population is currently rising? The demographic forecasts show that the same kinds of gaps will begin to appear in China a decade or two out. What are the challenges and the opportunities for corporations?

HORI: …One challenge for corporations is losing a market…There’s a shortage of children; … There has to be a big market shift in terms of the corporate sector.

The second challenge is the workforce, because it is going to shrink as well. …There are several dimensions: One is the need to increase productivity through approaches like robotics and IT. The second is migrant and immigrant workers, … The third is offshoring, shifting the business to either China or India. …

S+B: Your mention of offshoring raises the question of the degree to which companies are going to be able to do demographic arbitrage — locating their headquarters and production in relation to where they can find an employee base or markets for their goods and services.

WANG: …One of the main costs of running a business is represented by the cost of fixed salaries, because salaries don’t go backward — they keep going upward; the same is true of health-care premiums and pension costs. It costs companies a lot to hire older employees. … Solving this problem would require innovation in financing pensions and health care so the companies aren’t bearing all the costs, as well as retraining and other issues. It will take a shifting — a redistribution — of social resources.

S+B: Is the challenge in filling skills gaps different for service industries, where the services are provided in the home market and the jobs cannot be outsourced?

HORI: Yes, it is different. In Japan, it’s in these industries where we’ve seen foreign workers come in recent years as the workforce has been aging. Many have lost their jobs or have gone back to their home countries because of the economic downturn, and it’s going to be difficult to attract them again. So there will be some needs in the service sector. But the service sector is also where we’re seeing large productivity increases. Fewer and fewer workers are needed, largely because of the Internet. The volume of sales in e-commerce is going up, and the number of retail shops is going down.

MA: I think there’s another side to that, in that companies could change a lot of their mechanisms and procedures and IT systems to cater more to older employees. There are many ways for workers to deliver services and care from their homes, for example. … I think we could develop job redesign processes to equip elderly people with basic skill sets and some IT technology, to do this kind of work from their homes. …

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S+B: Is there a greater need for coordination among the public, private, and nonprofit sectors?

LEHMANN: I do think there needs to be collaboration, … I totally agree that businesses are looking for profits and by definition have to work on a relatively short-term basis. … So if you start with the premise that companies are about profits, you need to push them to think about where the profits are going to be generated, and whether they are going to have the resources to generate them.

When you look at the demographic data, the bottom line is that on the one hand, you have the problem of aging populations, mostly in the developed world. On the other hand, you have the problem of an enormous population explosion taking place among the poor countries of the world.

The biggest demographic increase is going to be in Africa. By 2050, roughly 20 percent of the world population is going to be in Africa, up from 9 percent in 1900. … Just in the next decade, the youth dividend will be adding 250 million people in Central and South Asia, 9 million in Iraq, 9 million in Iran, 10 million in Afghanistan, 38 million in Pakistan … The population of Yemen is going to increase from 17 million today to 39 million in 2025.

This is the kind of thing that we need to talk to companies about. If you ask them, “Where are your computer engineers tomorrow?” …Well, they won’t be in China, or in Singapore. Your future computer engineers — your future workforce — has to come from Yemen, from Nigeria, from Pakistan. We need to think about how we are going to get people who will have the necessary skills. …

S+B: Could we envision corporations in developed countries founding schools in the Yemens and the Pakistans of the world and then building plants there or relocating or importing the workers?

LEHMANN: I think those are the kinds of things that will be needed. …

What must be done is to integrate issues like demographic change into the mainstream of the corporate strategy. … I’ll give you just one case, … I am acquainted with an Indian entrepreneur named Rajendra Pawar, who is cofounder of a very successful software company called NIIT Ltd., … NIIT is a pioneer in education-oriented technology. It developed a concept, … called Hole-in-the-Wall, which places free computers in public locations for kids in slums and in poor villages. … These kids, … gain computer literacy by teaching themselves simply through the availability of the computers. It’s a fantastic social experiment.

It is free — so there are no profits in the conventional sense. If you ask Raji Pawar why he’s doing this, of course there is an element of altruism, …. But he will also say that, basically, it’s expanding his market. …[The] more people who have basic computer competency and literacy, the more his market is going to expand and the more he is going to be able to make profits.

…I am quite convinced that companies would invest in developing human capacities if they could do it in a strategic way, such that, in Pakistan for example, they would reap the benefits in due course.

WANG: I think we need a fundamental change in public perceptions. Even if the labor force issues were solved, we’re still going to face fundamental problems as we adjust to aging populations. …Resources are limited, and we need to set priorities. There needs to be some focus in terms of how resources are spent on different segments of people, and better information, shared more widely, about the innovations that are succeeding in places like Japan and Singapore.

Reprint No. 10105

Roundtable Contributors:

• Yoshito Hori is dean of the Globis Management School, with campuses in Tokyo, Nagoya, and Osaka. He is also managing partner of Globis Capital Partners and author of several books, including Dear Visionary Leaders Who Create and Innovate the Society (PHP Institute, 2009), and Six Dimensions of Life (Kodansha, 2004). His blog, Views from an Entrepreneur, is at http://blog.globis.co.jp/hori_english.
• Jean-Pierre Lehmann is professor of international political economy at IMD in Lausanne, Switzerland, and is founding director of the Evian Group at IMD. Prior to joining IMD, Lehmann had a 40-year career in journalism, academe, and consulting that encompassed activities in virtually all Asian and western European countries, as well as North America.
• Timothy Ma Kam Wah is executive director of the Senior Citizen Home Safety Association in Hong Kong, a nongovernmental organization that runs a 24-hour lifeline and related services for the elderly and chronic invalids. He is president of the Hong Kong chapter of the Association of Fundraising Professionals and a cofounder of the Hong Kong Social Entrepreneurship Forum.
• Vanessa Wang is the Asia business leader of Mercer LLC’s retirement, risk, and finance business. Based in Beijing, she works closely with Chinese regulators on issues concerning enterprise annuity and investment policies. Her clients include multinational companies, local private and public companies, state-owned enterprises, and public-sector plans in Asia and the United States.
• Photographs of the roundtable contributors courtesy of the World Economic Forum

How companies manage sustainability

Most companies are not actively managing sustainability, even though executives think it’s important to a variety of corporate activities. Those that do are reaping benefits for themselves and for society.

McKinsey Quarterly

March 2010

More than 50 percent of executives consider sustainability—the management of environmental, social, and governance issues—“very” or “extremely” important in a wide range of areas, including new-product development, reputation building, and overall corporate strategy, according to the latest McKinsey survey.¹ Yet companies are not taking a proactive approach to managing sustainability: only around 30 percent of executives say their companies actively seek opportunities to invest in sustainability or embed it in their business practices, for example.

This survey explored how companies define sustainability, how they manage it, why they engage in activities related to sustainability, and how they assess as well as communicate this engagement.

Companies are defined as being most engaged with sustainability if their executives say that sustainability is a top-three priority in their CEOs’ agendas, that it is formally embedded in business practices, and that their companies are “extremely” or “very effective” at managing it.² … Energy companies, not surprisingly, also take a more active approach.

Why companies engage in sustainability

One potential reason so many companies don’t actively address sustainability despite the attention paid to it by the media and some consumers and investors is that many have no clear definition of it. … Among those that do, the definition varies: 55 percent define sustainability as the management of issues related to the environment … In addition, 48 percent say it includes the management of governance issues …, and 41 percent say it includes the management of social issues … .Fifty-six percent of all the respondents define sustainability in two or more ways.

Executives in business-to-business companies are likelier than their counterparts in consumer-facing companies to seek new growth opportunities through sustainability activities (20 percent, versus 14 percent).

Even with this range of definitions, most respondents see sustainability as creating real value…

The difference in views on short- and long-term value creation may be explained in part by the fact that building reputation is in a class of its own when compared with other, more immediately financial reasons for engagement such as alignment with the company’s business goals or improving operational efficiency. Indeed, 72 percent of respondents say considering sustainability is “extremely” or “very important” for managing corporate reputation and brands. In addition, 55 percent agree that investment in sustainability helps their companies build reputation, and 36 percent see building reputation as a top reason for addressing sustainability issues (Exhibit 1).

…But companies consider sustainability in a wide range of other business activities as well (Exhibit 2). …

Given sustainability’s importance, it’s surprising that only 27 percent of respondents say their CEOs or other C-level executives run their companies’ sustainability initiatives on a day-to-day basis.³ …

Uneven management efforts

Despite sustainability’s importance to various corporate activities, only a quarter of executives say it’s a top-three priority on their CEOs’ agendas. The lack of weight in leadership’s top agenda shows in the relatively small number of activities companies actually pursue related to sustainability… (Exhibit 3).

Companies where sustainability is a top-three priority on the CEOs’ agendas are likelier to pursue sustainability due to alignment with business goals (38 percent) than for building reputation (27 percent).

By contrast, senior executives in the energy industry take an active approach to managing sustainability, likely because of the potential for regulation and increasing natural-resource constraints. … Further, energy executives are much likelier than others to be active in seeking opportunities to invest in sustainability (40 percent versus 28 percent), to integrate it into their companies’ business practices (43 percent versus 29 percent), and to shape regulation actively (29 percent versus 16 percent).

Except among energy companies, reporting practices are relatively poor, considering the impact executives say sustainability has on business. Particularly in light of the role of sustainability in reputation-building efforts, for example, it’s surprising that companies do not take an active approach in communicating their initiatives externally (Exhibit 4). Indeed, 62 percent of respondents say their companies do not report sustainability metrics to investors or are unaware of their companies’ sustainability-reporting practices—even though more than 50 percent keep track of the value created by sustainability in terms of reputation building and cost savings (Exhibit 5).

The picture is again different for energy executives: 74 percent of energy executives incorporate sustainability when developing their companies’ regulatory strategies, compared with 53 percent of respondents overall. Similarly, 54 percent of respondents in the energy industry say their companies embed sustainability data in communications with investors, compared with 35 percent overall.

What the proactive do differently

Just over 6 percent of executives say that sustainability is a top-three priority in their CEOs’ agendas, that it is formally embedded in business practices, and that their companies are “extremely” or “very effective” at managing it. These engaged companies actively seek opportunities to invest in sustainability: 88 percent of the respondents in this group say so, compared with 23 percent of all others (Exhibit 6). …

Other findings indicate how much sustainability is a part of the fabric of these companies. Their executives, for instance, are more aware than executives at other companies of the metrics their companies track. … More importantly, among the group that is aware of what’s being tracked, the engaged companies are far more likely to be tracking relevant sustainability indicators such as waste, energy and water use, and labor standards for their suppliers and consumers.

In addition, these engaged companies do more than others to communicate externally the impact of their sustainability programs (Exhibit 7).

Dealing with regulation

Regulation, particularly environmental regulation, can have a very strong effect on companies’ sustainability activities. However, only about 35 percent of executives say their companies have quantified the potential impact of environmental and social regulation on their businesses; only 40 percent feel prepared to deal with regulation in the next three to five years and are personally confident about handling climate change issues. …

Looking ahead

• Seventy-six percent of executives say engaging in sustainability contributes positively to shareholder value in the long term. Companies that manage sustainability proactively are much likelier to seek and find value creation opportunities.
• Companies where sustainability is a top item in their CEOs’ agendas are twice as likely as others to integrate sustainability into their companies’ business practices. This suggests that senior executives who want to reap the benefits of incorporating sustainability into their companies’ overall strategies must take an active role in the effort.
• A first step to gain recognition and improve the impact of sustainability activities could be to communicate better with investors and other stakeholders.

Notes

¹ The survey was conducted in February 2010 and received responses from 1,946 executives representing a wide range of industries and regions.

² Energy companies, which are overall more engaged in sustainability activities than are companies in other industries (likely as a result of potential regulation and natural-resource constraints), were excluded from this group.

³ Also surprising, 11 percent of respondents say “no one” coordinates initiatives on a daily basis, and 5 percent are unsure.

About the Authors

Contributors to the development and analysis of this survey include Sheila Bonini, a consultant in McKinsey’s Silicon Valley office, Stephan Görner, a principal in the Sydney office, and Alissa Jones, a consultant in the Copenhagen office. They would like to acknowledge the contributions of their colleague Michaela Ballek.

When can you trust your gut?

Nobel laureate Daniel Kahneman and psychologist Gary Klein debate the power and perils of intuition for senior executives.

McKinsey Quarterly - Strategy - Strategic Thinking

MARCH 2010

For two scholars representing opposing schools of thought, Daniel Kahneman and Gary Klein find a surprising amount of common ground. Kahneman, a psychologist, won the Nobel Prize in economics in 2002 for prospect theory, which helps explain the sometimes counterintuitive choices people make under uncertainty. Klein, a senior scientist at MacroCognition, has focused on the power of intuition to support good decision making in high-pressure environments, such as firefighting and intensive-care units.

… In this interview with Olivier Sibony, a director in McKinsey’s Brussels office, and Dan Lovallo, a professor at the University of Sydney and an adviser to McKinsey, Kahneman and Klein explore the power and perils of intuition for senior executives.

The Quarterly: …“Under what conditions are the intuitions of professionals worthy of trust?” …

Gary Klein: It depends on what you mean by “trust.” If you mean, “My gut feeling is telling me this; therefore I can act on it and I don’t have to worry,” we say you should never trust your gut. You need to take your gut feeling as an important data point, but then you have to consciously and deliberately evaluate it, to see if it makes sense in this context. You need strategies that help rule things out. That’s the opposite of saying, “This is what my gut is telling me; let me gather information to confirm it.”

Daniel Kahneman: There are some conditions where you have to trust your intuition. When you are under time pressure for a decision, you need to follow intuition. My general view, though, would be that you should not take your intuitions at face value. Overconfidence is a powerful source of illusions, primarily determined by the quality and coherence of the story that you can construct, not by its validity. If people can construct a simple and coherent story, they will feel confident regardless of how well grounded it is in reality.

The Quarterly: Is intuition more reliable under certain conditions?

Gary Klein: We identified two. First, there needs to be a certain structure to a situation, a certain predictability that allows you to have a basis for the intuition. If a situation is very, very turbulent, we say it has low validity, and there’s no basis for intuition. …The second factor is whether decision makers have a chance to get feedback on their judgments, so that they can strengthen them and gain expertise. If those criteria aren’t met, then intuitions aren’t going to be trustworthy.

… Many business intuitions and expertise are going to be valuable; they are telling you something useful, and you want to take advantage of them.

Daniel Kahneman: This is an area of difference between Gary and me. I would be wary of experts’ intuition, except when they deal with something that they have dealt with a lot in the past. … One of the problems with expertise is that people have it in some domains and not in others. So experts don’t know exactly where the boundaries of their expertise are.

The Quarterly: Many executives would argue that major strategic decisions, such as market entry, M&A, or R&D investments, take place in environments where their experience counts—what you might call high-validity environments. Are they right?

Gary Klein: None of those really involve high-validity environments, but there’s enough structure for executives to listen to their intuitions. I’d like to see a mental simulation that involves looking at ways each of the options could play out or imagining ways that they could go sour, as well as discovering why people are excited about them.

Daniel Kahneman: In strategic decisions, I’d be really concerned about overconfidence. There are often entire aspects of the problem that you can’t see… An executive might have a very strong intuition that a given product has promise, without considering the probability that a rival is already ahead in developing the same product. I’d add that the amount of success it takes for leaders to become overconfident isn’t terribly large. Some achieve a reputation for great successes when in fact all they have done is take chances that reasonable people wouldn’t take.

Gary Klein: Danny and I are in agreement that by the time executives get to high levels, they are good at making others feel confident in their judgment, even if there’s no strong basis for the judgment (see sidebar, “Overconfidence in action?”).

The Quarterly: So you would argue that selection processes for leaders tend to favor lucky risk takers rather than the wise?

Daniel Kahneman: No question—if there’s a bias, it’s in that direction. Beyond that, lucky risk takers use hindsight to reinforce their feeling that their gut is very wise. Hindsight also reinforces others’ trust in that individual’s gut. That’s one of the real dangers of leader selection in many organizations: leaders are selected for overconfidence. We associate leadership with decisiveness. That perception of leadership pushes people to make decisions fairly quickly, lest they be seen as dithering and indecisive.

Gary Klein: I agree. Society’s epitome of credibility is John Wayne, who sizes up a situation and says, “Here’s what I’m going to do”—and you follow him. We both worry about leaders in complex situations who don’t have enough experience, who are just going with their intuition and not monitoring it, not thinking about it.

Daniel Kahneman: There’s a cost to not being John Wayne, since there really is a strong expectation that leaders will be decisive and act quickly. We deeply want to be led by people who know what they’re doing and who don’t have to think about it too much. …

The Quarterly: A moment ago, Gary, you talked about imagining ways a decision could go sour. That sounds reminiscent of your “premortem” technique. Could you please say a little more about that?

Gary Klein: The premortem technique is a sneaky way to get people to do contrarian, devil’s advocate thinking without encountering resistance. … Before a project starts, we should say, “We’re looking in a crystal ball, and this project has failed; it’s a fiasco. Now, everybody, take two minutes and write down all the reasons why you think the project failed.”

… If you make it part of your corporate culture, then you create an interesting competition: “I want to come up with some possible problem that other people haven’t even thought of.” The whole dynamic changes from trying to avoid anything that might disrupt harmony to trying to surface potential problems.

Daniel Kahneman: … My guess is that, in general, doing a premortem on a plan that is about to be adopted won’t cause it to be abandoned. But it will probably be tweaked in ways that everybody will recognize as beneficial. So the premortem is a low-cost, high-payoff kind of thing.

The Quarterly: It sounds like you agree on the benefits of the premortem and in your thinking about leadership. Where don’t you see eye to eye?

Daniel Kahneman: I like checklists as a solution; Gary doesn’t.

Gary Klein: I’m not an opponent of checklists for high-validity environments with repetitive tasks. … But I’m less enthusiastic about checklists when you move into environments that are more complex and ambiguous, because that’s where you need expertise. Checklists are about if/then statements. The checklist tells you the “then” but you need expertise to determine the “if”—has the condition been satisfied? In a dynamic, ambiguous environment, this requires judgment, and it’s hard to put that into checklists.

Daniel Kahneman: I disagree. In situations where you don’t have high validity, that’s where you need checklists the most. The checklist doesn’t guarantee that you won’t make errors when the situation is uncertain. But it may prevent you from being overconfident. …

The Quarterly: What should be on a checklist when an executive is making an important strategic decision?

Daniel Kahneman: I would ask about the quality and independence of information. Is it coming from multiple sources or just one source that’s being regurgitated in different ways? Is there a possibility of group-think? Does the leader have an opinion that seems to be influencing others? … Fragmenting problems and keeping judgments independent helps decorrelate errors of judgment.

The Quarterly: Could you explain what you mean by “correlated errors”?

Daniel Kahneman: …There’s a classic experiment where you ask people to estimate how many coins there are in a transparent jar. When people do that independently, the accuracy of the judgment rises with the number of estimates, when they are averaged. But if people hear each other make estimates, the first one influences the second, which influences the third, and so on. That’s what I call a correlated error.

Frankly, I’m surprised that when you have a reasonably well-informed group … that it isn’t more common to begin by having everyone write their conclusions on a slip of paper. If you don’t do that, the discussion will create an enormous amount of conformity that reduces the quality of the judgment.

The Quarterly: Beyond checklists, do you disagree in other important ways?

Gary Klein: Danny and I aren’t lined up on whether there’s more to be gained by listening to intuitions or by stifling them until you have a chance to get all the information. Performance depends on having important insights as well as avoiding errors. But sometimes, I believe, the techniques you use to reduce the chance of error can get in the way of gaining insights.

Daniel Kahneman: My advice would be to try to postpone intuition as much as possible. Take the example of an acquisition. Ultimately, you are going to end up with a number—what the target company will cost you. If you get to specific numbers too early, you will anchor on those numbers, and they’ll get much more weight than they actually deserve. You do as much homework as possible beforehand so that the intuition is as informed as it can be.

The Quarterly: What is the best point in the decision process for an intervention that aims to eliminate bias?

Daniel Kahneman: It’s when you decide what information needs to be collected. … If you’re starting with a hypothesis and planning to collect information, make sure that the process is systematic and the information high quality. …

Gary Klein: I don’t think executives are saying, “I have my hypothesis and I’m looking only for data that will support it.” I think the process is rather that people make quick judgments about what’s happening, which allows them to determine what information is relevant. … Rather than seeking confirmation, they’re using the frames that come from their experience to guide their search. Of course, it’s easy for people to lose track of how much they’ve explained away. So one possibility is to try to surface this for them—to show them the list of things that they’ve explained away.

Daniel Kahneman: I’d add that hypothesis testing can be completely contaminated if the organization knows the answer that the leader wants to get. You want to create the possibility that people can discover that an idea is a lousy one early in the game, before the whole machinery is committed to it.

The Quarterly: How optimistic are you that individuals can debias themselves?

Daniel Kahneman: I’m really not optimistic. … It’s a special exercise to question your own intuitions. I think that almost the only way to learn how to debias yourself is to learn to critique other people. I call that “educating gossip.” If we could elevate the gossip about decision making by introducing terms such as “anchoring,” from the study of errors, into the language of organizations, people could talk about other people’s mistakes in a more refined way.

The Quarterly: Do you think corporate leaders want to generate that type of gossip? How do they typically react to your ideas?

Daniel Kahneman: The reaction is always the same—they are very interested, but unless they invited you specifically because they wanted to do something, they don’t want to apply anything. Except for the premortem. …

The Quarterly: Why do you think leaders are hesitant to act on your ideas?

Daniel Kahneman: … Leaders know that any procedure they put in place is going to cause their judgment to be questioned. …

The Quarterly: Yet senior executives want to make good decisions. Do you have any final words of wisdom for them in that quest?

Daniel Kahneman: My single piece of advice would be to improve the quality of meetings… . … People should have a lot of information, and you want to decorrelate errors.

Gary Klein: What concerns me is the tendency to marginalize people who disagree with you at meetings. There’s too much intolerance for challenge. As a leader, you can say … everybody should share their opinions. But people are too smart to do that, because it’s risky. So when people raise an idea that doesn’t make sense to you as a leader, rather than ask what’s wrong with them, you should be curious about why they’re taking the position. Curiosity is a counterforce for contempt when people are making unpopular statements.

SIDE BAR--Overconfidence in action?

A December 2009 survey of 463 readers of mckinseyquarterly.com underscored the degree to which senior executives sometimes exhibit greater confidence than those further down in the organization. In response to the question “Does management admit mistakes and kill unsuccessful initiatives in a timely manner?” 80 percent of C-level executives said yes. In contrast, only 49 percent of non-C-level executives agreed with the same statement.

Executives responded to the survey after reading “Competing through organizational agility,” by London Business School professor Don Sull.

About the Authors

Daniel Kahneman is a Nobel laureate and a professor emeritus of psychology and public affairs at Princeton University’s Woodrow Wilson School. He is also a fellow at the Hebrew University of Jerusalem and a Gallup senior scientist. Gary Klein is a cognitive psychologist and senior scientist at MacroCognition. He is the author of Sources of Power: How People Make Decisions, The Power of Intuition, and Streetlights and Shadows: Searching for the Keys to Adaptive Decision Making.

The Next Asset - Financial Planning

The Next Asset - Financial Planning With small- and micro-cap choices shrinking, should advisors turn to venture capital to fill the gap? By Joan Allen Schriger and William Banks Traditionally, those seeking additional growth would consider increasing exposure to small- and micro-cap equities to juice up potential returns. The problem, though, is that this asset class just ain't what it used to be. The Sarbanes Oxley Act of 2002, ... has created an environment where the most innovative companies-... are opting to stay private until they are more mature. What's left in publicly traded micro- cap, ... is a bit of a used car lot. To a great extent, the micro-cap space was diluted by mature companies whose businesses are flat or declining. Today, over 40% of the companies in the index are in financial services, durables, consumer staples or utilities-not sectors typically equated with high growth. For those seeking the risk/return characteristics that small and micro-cap used to exemplify, we believe the best opportunity resides in the private marketplace of late-stage venture capital. There are some practical challenges, however. Access is critical. The trouble is, venture capital has long been an exclusive club. ... Typically, there are limited LP slots available to invest in VC funds and the top funds are oversubscribed through legacy relationships. So, how does one incorporate venture as a part of a core portfolio allocation-...? ... Many advisors and consultants have structured SPVs (special purpose vehicles) specifically to accommodate these opportunities for their clients. These vehicles may be structured as LLCs, LPs or other pooled investment vehicles. Whatever the structure, the purpose is to pool together either direct deals or limited partnership interests in order to allow clients to get broader diversification in manageable investment increments. This is one way to go, and it allows for diversification across a client base where daunting minimums might otherwise prove insurmountable. The next wave is toward providing institutionally managed structures that make these private investments more accessible and economical for a broader group of investors, and that allow for better integration with the core portfolio. ...

A Yale Tale - Financial Planning

A Yale Tale - Financial Planning The Yale Endowment Fund has excelled through all kinds of markets. Is it possible to build a similar portfolio that is accessible to everyone? By Craig L. Israelsen

Effect of deregulation on pricing strategy

When industries deregulate, their managers face unfamiliar challenges. Price wars are often the unfortunate—and unnecessary—result.

McKinsey Quarterly - Strategy - Strategic Thinking

AUGUST 2001 • Andreas Florissen, Boris Maurer, Bernhard Schmidt, and Thomas Vahlenkamp

In This Article

• Exhibit 1: Pricing panic
• Exhibit 2: Consumers are reluctant to switch
• Sidebar Exhibit: A model for optimal pricing

The wrong pricing strategy can destroy corporate value faster than almost any other business mistake. And when industries are about to be deregulated, managers habitually adopt ill-conceived pricing policies that are almost guaranteed to damage their companies and erode services to customers and the community.

These flawed pricing policies … represent efforts to hang on to customers. Managers cut prices preemptively to fend off new rivals and then launch full-fledged price wars in hopes of outlasting attackers and emerging victorious from the rubble. This, at any rate, is the hope; the reality is usually quite different. …

One example of such pricing behavior comes from the Chilean telecommunications sector, which deregulated in 1994. Before then, Empresa Nacional de Telecomunicaciones (Entel) had been the sole provider of domestic and international long-distance services, but with the coming of deregulation Entel had to compete against seven rivals. At first, hoping to keep its customer base intact, it joined in a price war. By the end of 1994, rates for calls from Chile to the United States had fallen by about 95 percent, and domestic long-distance rates had collapsed similarly (Exhibit 1). Despite the price cuts, Entel lost nearly 70 percent of the domestic long-distance market and more than half of the international one. After 1994 Entel stopped competing on price. Differentiating itself from competitors on the basis of service and broad product offerings, it began charging a premium over the rates of its largest rival. New entrants continued to threaten Entel's international business, but by the late 1990s the company had recovered some of its domestic long-distance market share.

Lower prices for customers are among the primary goals of most deregulation efforts. … But if misguided policies spur struggles that bring prices below the level needed to cover costs, neither companies nor consumers win… And if a price war succeeds in destroying all attackers, a shattered market will be left with little competition.

In most cases, established companies launch price wars believing that once the dust has settled, prices will rise again. But psychologically and politically, it can be far more difficult to orchestrate a price increase than a price cut. … In our analysis, optimal prices for incumbents can be as much as 20 percent higher than those they actually set. …[Incumbents] must be prepared to lose some of their customer base. Nonetheless, if the right factors influence their pricing decisions, they and the market will remain healthier.

Four factors

An examination of deregulated markets, mostly in Europe, has taught us that the incumbents' managers tend to make the same mistakes when they address the problem of pricing. …

Often the incumbents misinterpret or ignore four key factors that should influence their pricing strategies: competitors' prices, switching rates, customer value, and cost to serve. When all of these factors are weighed correctly, incumbents often find that they can actually charge a premium over attackers' rates, and this discovery may well be the key to their continued profitability.

1. Competitors' prices

In the deregulating markets we have examined, the most important influence on pricing decisions is competitors' prices. … More often, when facing multiple attackers, incumbents almost by default worry about the lowest price being offered rather than the most relevant. Incumbents, in setting their own prices, should focus on those of the competitor that is best known in the market and has the greatest chance of luring away customers. …

What is more, a former monopolist generally underestimates its competitors: believing that it can outlast any of them, it sets prices without fully anticipating the speed and vehemence of their pricing reactions. Incumbents are often unpleasantly surprised by how long the competition can sustain low prices even when they fall below the cost to serve. …

2. Switching rates

As soon as the customers of a monopoly can choose another supplier, some of them will inevitably do so, and others will follow if the incumbent charges more than its rivals. This switching rate is a second factor that must be weighed in setting price levels in newly liberalized markets, though incumbents actually tend to overestimate the amount of switching that price differentials are likely to trigger.

These inflated estimates are based on the often exaggerated ideas of executives at incumbent companies about how much time their customers spend mulling over their services. … [Comparatively] few customers even consider switching unless the advantages, such as a large price differential, heavily outweigh the bother of changing providers. …

… Our analysis of several markets in the years after liberalization shows that incumbents charging a 5 percent premium endured switching rates that actually never exceeded 2 percent of the customer base a year (Exhibit 2). After peaking immediately following deregulation, the rate actually fell. Of course, as price premiums increase, so does the likelihood that a larger proportion of customers will jump to an attacker.

3. Customer value

Few things are more dear to the hearts of incumbents than their customer base, but the quixotic effort to retain a 100 percent market share leads them to misunderstand the value of their customers. In the prevalent view, all of them have the same high value, but that just isn't right: their individual value varies … Although an ex-monopoly must keep a substantial share of the market, keeping all of it is impossible.

Fortunately, one of the factors that determine the value of customers is their readiness to jump to the competition. If a customer is the kind of person who switches easily, retention efforts are better directed at others, since the likelihood of success is small. … Managers must understand that it is better to lose fickle customers than to keep them at unrealistically low prices—an approach that cuts margins earned from all customers, even those who are less price sensitive.

Traditional volume-driven customer strategies usually reflect inexperience in acquiring (or, in this case, reacquiring) customers, … Incumbents tend to assume that a customer, once lost, is lost forever.

4. Cost to serve

The final factor that incumbents often misjudge is the true cost of serving individual customers. In a controlled market, incumbents generally calculate their prices by adding an acceptable profit margin to their total costs rather than taking the time to determine the cost of serving individual customer segments. …

An incumbent's own costs should serve as an absolute short-term price minimum. …

Making reasoned decisions

By intelligently evaluating the four factors, incumbents can make more reasoned decisions about how to revise their pricing policies in the face of increased competition (see sidebar, "Using the factors"). Rather than blindly undercutting attackers, incumbents can safely charge private customers and most commercial accounts a premium that secures their business, avoids costly price wars, and preserves the market.

But this premium is not without complications. First, of course, the incumbent must be willing to shed a portion of its customer base, probably as much as 20 percent in the first year. Determining the acceptable level of customer losses early helps managers ride out the first shock of lost market share. … In addition, incumbents should include in their pricing policies certain triggers—such as levels of market share or competitors' prices—that would initiate changes in policy. Conditional pricing can free managers to turn their attention to other important issues.

Of course, closer attention to pricing isn't of benefit solely to companies in deregulating markets: the model distilled from them can be adapted to other situations characterized by intense price competition. …

Pricing is an important value lever, but many managers in deregulating markets have trouble determining the right price for products and services. These managers, misinterpreting or ignoring the four factors that inform rational price setting, embark on self-destructive attempts to keep customers at any cost. They must learn a tough lesson: that to optimize value, it is necessary to lose customers.

Using the factors

The optimal price for a product or service—the price that can help assure profitability and long-term financial health—can't be revealed solely by the four key factors (competitors' prices, switching rates, customer value, and cost to serve) that should influence pricing in deregulating markets. It is also necessary to determine the relationships among these factors, which must be linked to the optimal price premium. We have devised a model that shows incumbents the size of the price premiums they can charge when new competition arrives (exhibit).

First, the model sets a demand curve against profit margins, or price less cost. Demand for the services of an incumbent, as represented by its customer base, is steady until its prices rise higher than those of the most formidable—in other words, not necessarily the cheapest—attacker in its market. At this point, demand will start to decline. The slope of the declining demand curve is primarily a function of the market's switching rate; the more likely customers are to switch, the steeper the slope will be.

Second, the model charts the total marginal contribution, or revenues less cost, against the margin. At both extremes, the total marginal contribution is zero. Where price equals cost to serve, the margin is zero, and no matter how many customers are served, the total marginal contribution is also zero. At the other extreme, the price and the marginal contribution are so high that all customers switch. The curve, which is easy to model, shows that the total marginal contribution peaks somewhere beyond the line representing the main attacker's price. At this level, the incumbent charges a premium that maximizes the total current marginal contribution and accepts the inevitable loss of some market share.

But the premium level that maximizes the current marginal contribution doesn't take into account future customer value, including any additional margins that would result from price premiums in the future, profit potentially generated from cross-selling, and the cost of reacquiring customers. Incorporating future customer value into the model has the effect of moving the optimal price lower, assuming that there are unrealized benefits in retaining more of a company's customers. This final price helps to secure a company's future earnings while still preserving a price premium that makes current operations profitable.

About the Authors

Andreas Florissen is a consultant and Thomas Vahlenkamp is a principal in McKinsey's Düsseldorf office, and Boris Maurer is an associate principal and Bernhard Schmidt is a consultant in the Berlin office.

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

In This Article

• Exhibit 1: The research analyzed a variety of decisions in areas that included investments in new products, M&A, and capital expenditures.
• Exhibit 2: Process has a greater effect on decision making than analysis or industry variables.
• Interactive: How cognitive biases affect strategic decision making

• About the authors

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.

Five Gates to Innovation

Corning Inc.’s process for developing inventive products actually works, a claim that few companies can make.

strategy + business magazine

by William J. Holstein

By 2007, some cell phone makers were at their wit’s end about the screens on their devices. … Sensing a business opportunity, a small team in the specialty materials division of Corning Inc. dug out of the company’s archives the formula for a superstrong but flexible glass — something called Chemcor, which Corning had unsuccessfully attempted to introduce in 1962 for automobile windshields — and sought to test it for mobile phones.

…[The] team’s boss, Senior Vice President and General Manager James Steiner, was opposed to the idea. …

However, team leader Mark Matthews was persistent — and his hunches had been right before. …

Trusting Matthews’s instincts once again, Steiner finally relented and gave the go-ahead for the cell phone glass test run at a company facility in Danville, Va. …

Today, after only a couple of years on the market, Corning’s cell phone glass — now known as Gorilla — is a huge success. …Gorilla is selling at an annual rate of $100 million and is projected to become a $500 million business by 2015. That will make it a significant revenue stream for Corning, whose sales in 2009 totaled $5.4 billion.

In Record Time

Like other top companies, Corning has a rigorous system for managing ideas through a stage-gate process in which they are embryonic in Stage 1 and commercially marketed in Stage 5. But in Corning’s case, the system actually produces consistent results; …

What Corning appears to do better than most is insist that innovation be managed not by individual inventors or small teams in silos, … but by multidisciplinary groups throughout the organization. Overseeing this process and making sure that Corning departments cooperate in product development efforts sanctioned by management are two bodies: the Corporate Technology Council, led by Executive Vice President and Chief Technology Officer Joseph Miller, and the Growth and Strategy Council, cochaired by Corning Chairman and CEO Wendell Weeks and President and Chief Operating Officer Peter Volanakis. The former unit concentrates on early-stage ideas, and the latter takes over when an idea is nearing commercialization.

In Gorilla’s case, once the test run had been completed and customers grew excited about the possible product, Steiner had to gear up the whole organization, reaching across traditional turf lines to obtain scientific, management, and sales help. …

Convincing the Researchers

The key source of technical expertise was Sullivan Park Research Center in Erwin, N.Y., the company’s heralded R&D facility, …To recruit a group of scientists for the Gorilla project, Steiner enlisted his business technology manager, Xavier Lafosse, who also works for the top brass at Sullivan Park in a dual reporting arrangement Corning designed to facilitate joint activities between the commercial units and research teams. …

Sampling began in December 2007. Four months later, Corning won its first Gorilla customer, and by June, full-scale production and marketing were under way — a fast track through the stage gates that posed any number of challenges. For one, Steiner had to find a melting tank to manufacture Gorilla in large batches because the Danville facility couldn’t handle such an ambitious effort. He approached his colleagues in the much larger and highly successful display division and was able to obtain tank space in a plant in Harrodsburg, Ky. “We kind of had to wedge in,” says Steiner.

Company Expectations

That Steiner could even accomplish that illustrates a key advantage of Corning’s innovation process. …[Executives] approached by Steiner had little to gain from working with him because their compensation was based primarily on meeting their own targets — Corning’s division heads recognize that the company expects them to support promising new product launches. …

Throughout the development of Gorilla, Steiner made sure that the scientists attached to the project were meeting face-to-face with possible customers. “We have to create demand, and our scientists are one of our best commercial weapons,” Steiner says. “The credibility they give us is more than we can grow on our own.” Moreover, Corning officials say, by talking to customers frequently, the researchers can at times anticipate their needs.

As the Gorilla project raced toward its last stage gate, it soaked up more and more resources at Corning; as a result, other projects had to be pared away. …Corning’s response is to maintain the backlog of development efforts as live but unstaffed and to avoid laying off researchers in favor of moving them to ongoing development programs. …

Add it all up, says Rebecca M. Henderson, a Harvard Business School professor who has studied innovation and knows Corning well, and Corning is able to maintain an equilibrium that other companies struggle to find. …

Author Profile:

• William J. Holstein is a veteran business journalist and author based in New York. For more of his work, visit www.williamholstein.com.