Improving organisational decision-making

AUTHOR: Lachlan Colquhoun   DATE: 06.08.06   ISSUE 1, 2006

In his research at AGSM and his work with McKinsey and Company, Associate Professor Dan Lovallo’s focus is on the human factor in the decision-making process and ways to avoid common pitfalls – from over-optimism to risk aversion to blindly following the chief executive.

Professor Lovallo, who has a PhD in Behavioural Economics and Decision Science from California University at Berkeley, has published a number of thought leading articles in the McKinsey Quarterly which crystallize his study and experience as a consultant.

When judging the likelihood of potentially positive outcomes, human beings have an overwhelming tendency to be over-optimistic or over-confident.

Illustration: Gregory Baldwin

The most recent article, “Distortions and deceptions in strategic decisions” - written with Olivier Sibony from McKinsey’s Paris office – enters new ground in its analysis of how any decision with an element of risk is subject to “universal biases such as over-optimism and loss aversion.”

The article follows two other published works which look at situations of either market entry, or market exit, and explore how organisations can protect themselves by implementing principles which remove bias from the decision making process.

In the article “Beating the odds in market entry,” Professor Lovallo looks at how systematic errors in the way people process information can doom new market entrants to failure. Cognitive biases, he says, often undermine the planning and decision-making of otherwise astute executives.

The third article – “Learning to let go: making better exit decision”- examines how, when faced with a failing product or division, companies can tend to hang on too long. Common psychological biases help explain why executives downplay evidence and failure, and put off the tough decision to bail out.

Professor Lovallo says that in his role as a consultant, he has often witnessed some of these errors “at first hand” and seen how organisations and their leaders ignore the lessons of the past, and fail to learn from observing the mistakes of others.

Associate Professor Dan Lovallo’s focus is on the human factor in the decision-making process and ways to avoid common pitfalls.

“When firms are going to enter new industries, for example, they almost never think about what the reaction of the competitor is going to be,” he says.

“They always make plans about what they are going to do but they rarely make plans about what the competition is going to do, and so they don’t factor those reactions into their planning. Very often they are caught flat-footed.

“People just have a natural tendency to think about what the focal factor is, and if they are involved in a situation they are the focal factor and so they just have the blinkers on and they are just thinking about the actions they can take, rather than the environmental things that can happen – like a competitor’s reaction for example.”

Professor Lovallo sees his consultancy work with McKinsey as a crucial part of his research.

“For me, getting my hands dirty is part of the research process and that helps me come up with research which is of some use to managers,” he says.

“Companies can’t afford to ignore the human factor in the making of strategic decisions.”

Usually working with the chief executive of an organisation or business unit, Professor Lovallo describes his consulting work as suggesting an individually tailored risk management framework which can protect the organisation from poor decision-making.

The next step in his research, he says, is to develop an “organizational diagnostic” methodology organisations can use to understand the robustness of their decision-making, and correct errors.

“You try and understand what types of errors an organisation is making,” says Professor Lovallo.

“Is their decision making leading them to take on too much risk they are unaware of because they are overly optimistic? Or are they not taking on enough risk because the culture is one where you get punished for failure?

“Recognising and addressing this effectively is where I’d like to get to with my research.”

In his “Distortions and deceptions” article, Professor Lovallo describes several common scenarios where human shortcomings bias decision making.

In one scenario, for example, a company decides to proceed with a large merger opportunity largely because the most vocal proponent of the deal would benefit by running a larger division and positioning himself as the successor to the chief executive.

“When judging the likelihood of potentially positive outcomes, human beings have an overwhelming tendency to be over-optimistic or over-confident: they think that the future will be great, especially for them,” Professor Lovallo writes.

“In the making of strategic decisions, optimism not only generates unrealistic forecasts but also leads managers to underestiminate future challenges more subtly – for instance by ignoring the risk of a clash between corporate cultures after a merger.”

As well as over-optimism, he observes the phenomena of “loss aversion” and illustrates the case of a mid-level manager who was faced with making a $2 million capital investment which had a 50:50 chance of failing, or returning $10 million.

Pre-occupied with the impact failure would have on his reputation and career prospects, he decided not to proceed. Most organisations of any size should clearly welcome prospects like this.

"Try and understand what types of errors an organisation is making."

The final phenomena, which he calls “champion bias,” occurs in situations where people in organisations suppress their own reservations and opinions and align themselves with the CEO’s real or assumed point of view.

The common characteristic of all of these scenarios is deception. The strategic decisions are influenced by employees who are driven by their own interests, which are out of alignment with that of the organisation. The deception occurs because these motivations are either unrecognized or not mentioned.

The good news, however, is that Professor Lovallo believes his work can help organisations identify their susceptibility to these shortcomings, and implement processes which can reduce their exposure.

“Companies can’t afford to ignore the human factor in the making of strategic decisions,” he writes.

“They can greatly improve their chances of making good ones by becoming more aware of the way cognitive biases can mislead them, by reviewing their decision-making processes, and by establishing a culture of constructive debate.”