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The shocking financial consequences of how we think

Niall Ferguson’s best-selling and televised “Ascent of Money” covers beautifully the evolution of the financial system from ancient Mesopotamia to today. It is a superb book that relates the crucial role of financial tools in the growth and decline of empires and dynasties. Ironically, in amongst this excellence, the chapter that resonates most strongly is the afterword. This is called, suitably and contemporaneously, The Descent of Money.

The theme of that chapter, and this article, is how our hard-wired thought processes cause us to make decisions with a mindset that was useful for our evolution, but that in business and finance is destructive and irrational. He lists a series of cognitive traps – ways in which we make poor decisions without realising it.

We at Latitude recognised every single one of these traps, both in ourselves and in the companies we support and review. We could also relate to the considerable damage that each one could cause if unchecked.

We illustrate some of these common traps in this article. The terminology is complex, but the ideas are simple and you will recognise every one. Even becoming aware that they exist should help avoid their destructive consequences. In the second half of this article, we attempt to go one step further in helping to steer clear of trouble and distress by proposing two well-tested answers that have been used by science and sport from their outset.

Trap 1: “Extending the present”

In this trap, the individual assumes that the present is good guide to the future; much better than examination of previous experience illustrates.

We see this at its most common in business planning where future revenues and costs are based on the present, plus or minus a small percentage. The reliable rule that we apply to such plans is that they will usually be wrong, though the future profit out-turn may end up being more-or-less the same with good management and a little luck. The alternative to extending the present – acknowledging that we are much less knowledgeable about the future than we think we are – is a more uncomfortable state of affairs; but this more realistic mindset can lead us to adopt valuable approaches such as scenario planning, which make us much readier for when the unforeseen does happen.

Trap 2: “Hindsight bias”

Hindsight Bias is the trap that causes people to attach greater probabilities to events after they happened than they did before they happened. Whereas in Extending the Present, people assume the present is a better guide to the future than it actually is, with Hindsight Bias, people over-rate the past as a reliable guide to the future.

When we attempt to learn lessons from the past, we must therefore make sure we cover the failures as well as the successes. For example, we can blithely look at many successful companies and conclude that they were much more focused in the services they offered than their more mediocre counterparts; that service or product focus is a pre-requisite for success in all market-leading companies. We could use this to conclude that we should rid ourselves of all products, services or skills except those that are part of this single core. However, if we look at the failures, we see that many of those companies were also very focused, but the successful ones were the minority that just happened to focus on the right thing. Looking at the full set of information, we would conclude that focus with no contingency plan is a high risk strategy, which more often than not will fail.

Hindsight Bias also leads us to project forward assuming that the models and mechanisms that worked in the past have a high probability of working in the future. We forget, or don’t realise, that what actually happened was the one of a myriad of possibilities that happened to be supported by the circumstances of the time. Stepping into the present, those myriad possibilities still exist and the chances of the future turning out as we project are much less likely than we think.

Trap 3: “Availability bias”

This trap causes people to base decisions on information that is to hand, usually in their memories, versus the information that they actually need, like the car driver who loses his keys at night and only looks for them under lamp posts.

We see this at its most dangerous in Board or management workshops where the day is being run on the basis that all of the important knowledge is in the room. We have even heard facilitators use this we-have-everything-in-our-heads-already as a key premise for the entire strategy that emerges.

This cognitive trap also biases us to recency and proximity – we don’t look back far enough for similar patterns or warning signs, and we don’t look far afield enough for analogous evidence of failure or success.

Trap 4: “Confirmation bias”

This trap causes people look for evidence to prove what they believe to be true, rather than looking for evidence to challenge it: why Tories read the Telegraph and Socialists read the Guardian.

We see this bias at its most damaging in investment cases for acquisitions and in business cases for investment of money and time into new ventures or projects. Even when employing a third party professional to assess the acquisition, venture or project, the investor or business manager will actually ask for affirmation or substantiation – “I’m just looking for confirmation of my hypothesis” – rather than “Challenge me and tell me where I’m wrong”.

Trap 5: “The affect heuristic”

This trap causes people to allow their beliefs and value judgements to interfere with a rational assessment of costs and benefits.

We find this most dangerous at either of two extremes: on the one hand where the decision maker is very passionate about a subject, or on the other where he is once-bitten-twice-shy.

In the former case, whilst we find it critical that managers be passionate about their products or services, this passion can blind the person to reality, and can be impossible to address without introducing a very senior individual with authority to challenge assertions with information.

In the once-bitten-twice-shy case, we have seen private equity companies abandon entire sectors following one painful loss, and refuse to entertain the most solid business case that shares even the remotest common characteristics of historic loss-makers.

Trap 6: “The problem of induction”

Induction is the process of generating a general rule from a series of observations. In the absence of clear indisputable deductive relationships, induction can be all a person has to go on. The problem of induction is that the brain will look for neat patterns and will try to create a general rule even if it is based on insufficient information.

In acquisitions, people can over-estimate the performance and prospects of a company by seeing how satisfied its customers are. This creates an overly-positive pattern from what is essentially a self-selecting group: non-customers and disgruntled ex-customers need including for the full picture. Another example of poor induction is where management projects forward on the basis of a new product’s first year’s sales and forget to consider that this first year was a golden year, where everyone without the product bought one and would never need another.

A very common area where induction knows no bounds is in the practice of regression: correlating one factor against another to create what superficially appears to be a causal relationship. For example, it is possible to infer high price sensitivity when analysing price-volume relationships, and miss the over-riding effect of heavily marketed promotions that commonly coincide with lower prices. I was humbled to the limitations of correlation when an analyst working for me at my former company determined an almost 100% correlation between pallet demand and GDP. We started to doubt the causality when the analyst realised that she had used the wrong source data and correlated UK pallet demand with Polish GDP numbers. Our confidence in the causality was damaged further when the correlation with the “correct” driver, UK GDP, was about 30% lower.

Trap 7: “Overconfidence in calibration”

In this trap, people under-estimate the potential range of possible outcomes. In particular, people are often not sufficiently pessimistic with downside scenarios and/or attach too low a likelihood to major problems and pitfalls.

This issue is rife in business planning and financial projections. The more discrete and separate a business unit, the more visible is the variability; groups of partially-related businesses can appear easier to predict just because of the averaging of different under- and over-performing units. We often see business plans that overall are at or slightly below target, but consist of component businesses that show enormous variations from the original projections. For some reason, we as managers believe in our ability to perform within a tight range of projected expectations, despite this consistent evidence to the contrary.

Trap 8: “The fallacy of conjunction”

This is a trap in which people overestimate the likelihood that a series of highly likely events will all occur, and conversely underestimate the likelihood that at least one of a series of unlikely events will occur.

This leads management to believe that its mid-case scenario (which consists of all those highly likely events) is much more likely to happen that it actually is. The corollary is that it is reasonably likely that at least one of the many highly improbable, left-field, events will occur, and management will correspondingly be less likely to be ready for it.

We see this fallacy most often, again, in business planning, where a great deal of thought and preparation is given to the central scenario in the business plan, which from historic experience very rarely turns out to be true. It is why we at Latitude see business planning as a helpful process to prepare for possible futures, but see business plans as simply a means to this end.

Trap 9: “Failure of invariance”

This trap recognises that people are risk averse when prospects are positive but risk-seeking when they are negative. In a famous experiment, the vast majority of participants preferred a 100% chance of winning 500 pounds versus a 50% chance of winning 1,000 pounds. The same group preferred a 50% chance of losing 1,000 pounds versus a 100% chance of losing 500 pounds.

Companies approaching distress or who have experienced the initial failings of an investment seem to follow this risk-seeking tendency by trying ever more unlikely approaches to getting back their original money. It is almost always more rational and loss-minimising to write off sunk cost or a percent of equity, and to look at each decision on its own merits without the need to regain lost ground. Using share options as a reward mechanism can exacerbate this problem by actually making the risk-seeking rational for the individual manager, incentivising to act against the best interests of other stakeholders.

The other side of this coin, risk aversion when the company is ahead, is also very common and can lead to tremendous lost opportunity in new areas of business. This can be such a strong mindset in the team that created the company’s success that changing a winning team can sometimes be the only solution when seeking continued growth.

Trap 10: “Bystander apathy”

In this trap, people abdicate individual responsibility when they are in a crowd. Sometimes it is the apathy that stops anyone in a large crowd stopping a mugging; sometimes it is abdicating individual judgement to the perceived wisdom of the crowd. It seems that the risk of taking the contrarian path and being wrong is worse than being the anonymous lemming going over the cliff with all the others.

We see this in the various fads and booms that we fail to understand but cannot afford to miss out on. The recent “arbitrage” profits experienced in the world of private equity from ever growing P/E ratios is an example. Every Investment Director we spoke to when we surveyed them about this in 2006 knew that the P/E growth would need to stop at some stage, and admitted to stretching beyond managements’ business plans to make the investment case for purchase. But no-one felt they could afford not to keep investing. Everyone could see problems coming, and knew what would happen if they were left holding the baby when P/Es inevitably started shrinking, but to stop investing was to step out of the game.

There are numerous other cognitive traps, such as contamination effects from irrelevant data and scope neglect where we don’t minimise harm; but you probably already get the drift – people aren’t as rational as they think they are and they make irrational and potentially harmful decisions without realising it.

Two old-fashioned ways to overcome cognitive traps

In the sections above, we described ten “cognitive traps”: ways in which we think that can cause us to make damaging decisions without realising it.

The good news is that there are some decent tools to challenge these traps. We explain our two favourite approaches below, as lessons from science and sport.

1. A lesson from science – treat your beliefs as a hypothesis to be challenged

True science is not about test-tubes, double-blind tests and professors with moon-shaped glasses and speech impediments. It is about starting with a premise that you believe may be true – a hypothesis – and challenging it to see if you are right, or more likely, where you are wrong. Under this definition, you are more likely to see science from a good plumber trying to work out why your central heating makes a knocking noise than you are from a PhD nutritionist with research sponsored by High5, trying to persuade you that High5 is better than Powerade. The plumber is the scientist, challenging his hypothesis in search of the truth; the nutritionist is no more than a fundamentalist seeking and selecting evidence to support his initial position. Unfortunately, when we get attached to our ideas, the cognitive traps make us act more like the nutritionist than the plumber.

This is why the true scientist needs to adopt a mindset of challenging the hypothesis with data, and to have no belief that the hypothesis is true until the challenges show it to be so. Some practitioners even go as far as setting up a formal challenge in the form of an antithesis, an alternative hypothesis that is posited as a more accurate or insightful version of reality. This approach isn’t confined to the material and commercial – the Catholic Church appoints a devil’s advocate to provide the rigour of challenging its most important decision, the legal system applies the rigours of having separate representatives of both sides of the case.

So, how to apply this? Treat your belief as a hypothesis and challenge it, if necessary with your own devil’s advocate, to whom you give the seniority and power to challenge your decisions. And honestly expect your hypothesis to change as the evidence emerges.

Applying this lesson from science stops us being blind to the evidence at hand, but it doesn’t help us predict a future that is much more random that we think it is, or stop us being over-confident in our ability to predict it. To prepare for this, we take a lesson from sport.

2. A lesson from sport – prepare for a range of scenarios

A lesson learned by those of us who have been on the wrong end of a drubbing on the sports field or, more seriously, have experienced military action, is that no plan survives contact with the enemy. Whether you are a batsman facing a spin bowler about to treat you to one of his box of tricks, or a tennis player trying to decide if your opponent is stretched enough for you to approach the net without being passed or lobbed, you have to be able to cope with a range of scenarios. It doesn’t mean that your core game plan needs to be dictated by the opponent and environment, but it does mean that you need to be prepared for the range of scenarios that might play out. If you can’t deal with the high ball, you can guarantee that a good opponent will be sending up bombs for you to panic under all afternoon.

In business, the normal corporate downside scenario is maybe a 5% or 10% decline versus base case, which isn’t really a scenario at all, but more of a smaller version of the base case. A more useful scenario is to work out how we would still thrive if sales fell by 30% or 50%, or how we would grow if competitive substitute product X gained critical mass. How would we deal with costs? Where would we still invest, or even increase investment? Which divisions would we let go? What resources would we try to acquire? What we are not doing here is trying to create a plan for every single situation that might come about. What we are doing is stretching our thinking, in order to understand those common things we need to do to thrive in whatever scenario might come about, and preparing ourselves to respond to the inevitable unpredictability.

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