Jul

3

Hidden flaws in strategy (part un)

Filed Under business, entrepreneurship, product management, self improvement, strategy, things to remind myself, winds of change 

The McKinsey Quarterly has an interesting piece titled “Hidden Flaws in Strategy”, authored by Charles Roxburgh. What I like about this article is that it forces one to think about your blind spot, and provide solutions on how to overcome your own bias. A blind spot is well, very self-explanatory, which is why I think that’s just all the more reason why people, especially those who do any kind of strategy, should read this well put together article.

I’ll sum up some of the key takeaways to me, but reading the original piece of McKinsey is highly recommended.

Here are the common strategy flaws.

Flaw 1: Overconfidence

Our brains are naturally wired to make us overconfidence. This can be a good thing, because otherwise no one in their right mind would want to launch a new startup. However, we hurt ourselves when we try to make accurate estimates. Given a test question like “How heavy is a fully laden 747?” where participants are asked to give an answer where they were 90% confident, most people would rather be precisely wrong than be vaguely right.

Lesson learned: Be skeptical of strategies premised on certainty, and (duh) give yourself some wiggle room.

Flaw 2: Mental Accounting

Richard Thaler, a theorist in behavioural finance named the concept of mental accounting, defined as “the inclination to categorize and treat money differently depending on where it comes from, where it is kept, and how it is spent.” Some examples of mental accounting in the boardroom:

  • imposing caps on core business while throwing money at a startup
  • writing off money spent with conveniently created categories such as “revenue-investment spend” or “strategic investment”

Lesson learned: Don’t be so quick to throw away “so what if we throw it away” money. Eval potential investment through the standard scrutiny process, regardless of how the money fell into your lap.

Flaw 3: Status quo bias

An experiment conducted by Samuelson and Zeckhauser discovered that when students were asked how they would invest a hypothetical inheritance of millions of dollars, they adopted a “let’s leave things where they are” approach. That is, if the inheritance was already in high-risk high-yield stocks, it would be left as is. If the inheritence was already in low-risk low-return bonds, it would also be left as is. They opted not to rebalance the allocation in this hypothetical portfolio, even if it wasn’t in accordance to their risk preference.

The explanation is that people are more concerned about the fear of loss more than they are excited by the prospect of getting more. That’s the status quo. That’s what makes entrepreneurs special–they are not the status quo.

The other explanation is the endowment bias. Thaler discovered in an experiment with Cornell students that they wouldn’t pay more than $2.75 for mug with a Cornell imprint, but if they were given one, they wouldn’t sell the same mug away for less than $5.25–did the free market suddenly decide that the same mug has more value when it was already in someone’s possession when the same mug (a brand new one available for purchase) would be worth less? I think not.

While conservatism can be a strategic asset, it is important to distinguish between a status-quo option that is genuinely the right thing to do vs. one that just “feels safe” because of our innate bias.

The solutions Roxburgh suggest for strategists:

  • Adopt a radical view of all portfolio decisions: view all business as “up for sale”. Is the company the natural parent, capable of extracting the most value from a subsidiary? View divestment not as a failure but as a healthy renewal of the corporate portfolio (don’t let your ego get in the way)
  • Subject status quo options to a risk analysis as rigorous as change options receive. Most strategists are good at identifying the risks of new strategies but are less good at seeing the risks of failing to change

Flaw 4: Anchoring

From Wikipedia: Anchoring or focalism is a cognitive bias that describes the common human tendency to rely too heavily, or “anchor,” on one trait or piece of information when making decisions […] Take, for example, a person looking to buy a used car. They may focus excessively on the odometer reading and model year of the car, and use those criteria as a basis for evaluating the value of the car, rather than considering how well the engine or the transmission is maintained.

Anchoring is one of the oldest negotiation tactic in the book, if you haven’t heard of this, do pay attention here.

When putting up a company for sale, naming a high and slightly ridiculous sale price works to the benefit of the seller because negotations to talk to price down by the buyer would be anchored from that number. Sounds familiar? Car salesmen do this. Any salesmen good at making their quotas would know this.

Heck, even during a job offer (it’s a negotiation!), one party has to throw out a number. The prospective employee would lob a higher number, if he/she went first. If the company went first, it would be in their best interest not lob as high of a number, since the prospect would probably try to negotiate up, but at least that person would anchor the increase from the low number–unless of course, the prospect is not dumb enough to be blinded by this tactic in the first place.

Another example: statistics have shown that there is no correlation between a retail-fund manager’s good past performance and future performance, yet the fund managers always use their past performance as a selling point–and it still works on people!

Lessons learned: Being anchored to the past can be damaging. Put trends in context of long term historical outlook for economic indicators.

My hero Elon Musk discussed this in this brief interview at TieCon, where he says that people with critical thinking skills are in short supply. When Elon started his space company, everybody told him it would fail. However, he felt that they drew that conclusion based on an underlying premise that he felt differently about, and after careful re-examination, decided to proceed with SpaceX.

Flaws 5 through 8 on my second blog post, stay tuned — and have a Happy July 4th! I <3 you America.

TieCon 2008:

Elon Musk & me
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