Tuesday, April 26, 2016

Why We Make Bad Decisions

The simplest answer to the question may be "to err is human." We are not referring to honest mistakes that we may commit occasionally - after all, no one is infallible. What we are examining is our propensity to make decisions even when the evidence stares us in the face that the consequences could be disastrous.

Malcolm Gladwell provides an interesting phenomenon in his best-selling book Blink, where he introduces the concept of autonomous decision making - a process of thinking without thinking. Such a process has its origins in intuition, cognition, and gut feeling. Before getting to some patently bad decisions, let us understand the mechanism of an exceptionally good decision made without going through analysis or synthesis.

On January 15, 2009, US Airways Flight 1549 took off from New York's LaGuardia airport headed towards Charlotte Douglas airport. Captain Chesley "Sully" Sullenberger was in command. As the aircraft was climbing to its designated altitude, a flock of birds hit the aircraft damaging both the engines and posing an imminent danger to the crew and the 150 passengers on board. Captain Sully decided (without consulting anyone) to return to LaGuardia and tried to turn the aircraft around. Within seconds, he took a second decision to try and land at New Jersey airport. He was cleared for landing by ATC. Again within seconds, he decided to "land" the aircraft on the ice-cold waters of the Hudson river. The aircraft hit the water, bounced just once, and all the passengers and crew members were evacuated and rescued by boats that reached the scene within four minutes. There were a few minor injuries but amazingly no fatalities. The time taken from the bird-hit to the water landing: 2 minutes.

This is indeed a great example of "Blink" at work - a series of autonomous decisions made possible by three critical factors: the pilot's expertise in handling emergency situations, the 20,000 hours of flying experience that he had, and the fact that he was a certified glider pilot. However, as Gladwell cautions us eloquently, Blink is not for everyone and is certainly not for all situations.

Long Term Capital Management (LTCM) had two Nobel Laureates in economics, several management experts with doctoral degrees, and functionaries who had occupied some of the most exalted positions. The firm boasted using the Laureates' mathematical models to make investment decisions. LTCM used convergence trading to exploit deviations from fair value in the relationships between liquid securities across nations and asset classes. At its prime, the firm was earning annualized compounded returns of over 40%. It was the darling of the biggest banks and financial institutions. Then the inevitable happened. The Asian financial crisis coupled with the Russian financial crisis brought about the downfall of this much-touted company in just three weeks. Suddenly, it had an effective leverage ratio of more than 250 to 1. The Federal Reserve Bank of New York arranged a bailout to avoid a larger financial crisis. The year was 1998. History repeated itself ten years later but on a much larger scale. (For more on LTCM, please read Lowenstein, Roger (2000). When Genius Failed: The Rise and Fall of LTCM. Random House)

How could so many scholars and Ivy League school professors make such horrendous decisions? Part of the explanation may be found in the phenomenon of hubris - excessive confidence bordering on arrogance. All too often, leaders tend to think that they can make no mistakes. Unlike in the case of the US Airways aircraft and its commander, experience is the enemy. The assumption that is made time and time again is that what has worked in the past will work equally well in the future. If only life were that simple!

Or take the case of The Monitor group, a consulting firm founded by someone widely acknowledged to be the foremost guru on strategy. Thanks largely to the reputation of the founder, and that of the institution of which he is a part, the firm received assignments from governments, large corporations, non-profits and every type of organization one could imagine. The team of "specialists" who probably had never managed an enterprise, advised organizations and even countries how they could get ahead of competition. When the hallowed advice given did not produce the intended results, the downward slide began. The firm went bankrupt and was acquired by Deloitte. The moral here is that correlations can never provide glimpses into causalities and any theory, however profound, is subject to the environment in which firms have to operate. The firm also made the fatal mistake of accepting the then Libyan dictator as a client - and saw its reputation going out of the window. Constant denial added to the firm's cup of misery. Last, but by no means the least, execution is much more difficult than grand theories. It is a sad commentary that the genius behind the venture could not or chose not to grasp this harsh reality.

Finally, consider the case of Microsoft's offer to acquire Yahoo. The original offer was X and when the founder of Yahoo thought that the offer was too low, X was increased to Y. And then to Z. Just to place this in perspective, the difference between Z and X was $30 Billion. Yet, Yahoo's Board of Directors declined. What is Yahoo's valuation today? Please check it out. You will be surprised. Here, the bad decision was due to an emotional attachment. The history of management is replete with examples of entrepreneurs either refusing to let go or even step aside because after all the firm is "their baby." (Microsoft offered $45 Billion in 2008; Yahoo's current valuation is $35 Billion).

The next time you make an important business decision, please make sure you consider whether intuition or a thorough analysis is required. Be humble and accept that you are human. And leave emotion out of the equation. 

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