I teach behavioral finance. That is the study of how people make financial decisions and how those decisions differ from the perfectly rational. We are currently in the part of the semester that deals with corporations and how they vary from perfect rationality.
I teach behavioral finance. This is the study of how people make financial decisions and how those decisions differ from the perfectly rational. We are currently in the part of the semester that deals with corporations and how they vary from perfect rationality.
Anyone who has spent any time in business knows that business life is not perfectly rational. There are big ego’s, incorrect incentives, limited analytical resources and group think. The hierarchical nature of large institutions also increases the likelihood that the organization won’t respond timely, which is also irrational.
When we do the class I collect stories of corporate irrationality from the students. There are many. We also brainstorm techniques for staying rational at work.
Here are five techniques for CFO’s to add rationality to decision making. Three of these approaches can be attempted prior to embarking on the strategy, the last two are ways to are for after you’ve taken a path and it isn’t working.
1) What is the base rate for success on this strategy? Why should our efforts be any different than the base rate?
This technique is basically applying your circumstances to historical base rate stats, which is called Bayesian inference. A common application I’ve used this technique is estimating the likelihood of success for a new product. The base rate for product failure in the market is between 40-90%. For example, we’ve come up with a product concept that we feel is good, but faces several technical hurdles to reach the market. The chances of product success is then a function of the chances of success on each of the two steps: finishing the product and obtaining success in the market. Identifying the risks improves the planning process.
2) Conduct a pre-mortem. This is a concept that Gary Klein wrote about in the HBR, September 2007. The idea is to imagine that your project or strategy has failed spectacularly and then ask the question “Why did this happen?”. Hindsight is a powerful tool and it changes your perspective. Problems that were lurking in your subconscious get a chance to be aired. The resulting list of “reasons” for failure become improvements to the plan. Identifying timing, resource or scope issues prior to beginning the project results in cheaper and easier fixes. CFO’s are often the department of “no”. This technique allows you to get the whole team to think critically about a plan without being the wet blanket.
3) Stay intellectually and emotionally distant enough to use your judgement. Optimism and confidence in business are great. Being a part of a team that is conquering a market is a peak experience but that experience can blind CFO’s to reality. Denise Shull writes about using emotion to make better decisions. CFO’s and CEO’s, if good, live both inside the organization and outside. The outside perspective means that you are aware of the challenges within the business and secondly you can look at the business with a clear mind. Founders are, in general, terrible at this, but professional management can’t be.
Here are two techniques for after you are involved in a project that you think might be going bad.
4) If we knew then what we know now, would we still go ahead? This is a way of focusing on the sunk cost question. A full commitment to an ok strategy is better than a weak commitment to a great strategy. I’ve been in a lot of projects where significant investments of time and energy have been invested and then we find out a key fact that makes the project a lot less attractive. However, because we are all fully committed we ignore when key facts have changed.
5) “What would happen if somebody took us over, got rid of us — what would the new guy do?” asked Andy Grove of Gordon Moore in 1985, and this question is relevant for every senior executive. Firms get into ruts. Sometimes the answer is clear but because of institutional momentum management teams never think about the obvious choice.
Dr. John Zott is the CFO for Carlson Wireless Technologies, and Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are a former student, colleague or would just like to connect – reach out.