Behavioural Strategy

1. Behavioural Strategy Flanders Business School May 7 2010 CONFIDENTIAL AND PROPRIETARY Any use of this material without specific permission of McKinsey & Company is strictly prohibited

2. Research has identified dozens of biases that affect our decision making Illusion of control Groupthink Sunk cost fallacy Aversion to uncertainty Planning fallacy Confirmation bias Optimism bias Different perception of corporate goals Sunflower management Gambler’s fallacy Halo effect Need for closure Storytelling bias Authority bias Inertia Escalation of commitment Availability bias Hawthorne effect Selection bias Loss aversion Conjunction fallacy Anchoring and adjustment Von Restorff effect Not invented here Winner’s curse Texas sharpshooter bias Ingroup bias Status quo bias Cultural conflict neglect Agency effects Attribution error Silo thinking Overconfidence Short term thinking Emotional loss aversion (aka inappropriate attachments) Empire building SOURCE: Team analysis

3. We have identified ~17 key biases in 5 categories that affect strategic decision making • Confirmation bias • Management by example • False analogies, esp. misleading experiences • Power of storytelling • Champion bias • Excessive optimism • Overconfidence • Competitor neglect • Anchoring • Loss aversion • Sunk cost fallacy • Status quo bias • Misaligned incentives • Inappropriate attachments • Misaligned perception of corporate goals • Groupthink • Sunflower management SOURCE: Team analysis

4. Pattern recognition biases lead us to see patterns where there are none – for example the confirmation bias Definition • Examples • Business applications • Confirmation bias is • The over-weighting of evidence consistent with a favoured belief • Under-weighting of evidence against a favoured belief or • Failure to search impartially for evidence • Peter Wason's (1960) • Subjects seek to confirm their hypotheses rather than genuinely test them (identify a rule applying to triples of numbers: 2-4-6) • Johnson and Goldstein (2003) • Organ donations much higher where you donate by default • Peterson and Beach (1967) • Probability decisions are made conservatively • Anderson (1980) • Total discrediting of information does not make people ignore it when perceiving reality • Overweighting of facts that support current strategy, e.g., “management by anecdote” • Search for synergies that justify an acquisition price, rather than the reverse • “Pre-judging” of people’s proposals based on their individual track record or reputation • Using inadequate analogies from own experience to decide in a new situation SOURCE: Team analysis

5. Action-oriented biasesdrive us to take action less thoughtfully than we should – for example over optimism Definition • Examples • Business applications • Optimism bias is the demonstrated systematic tendency for people to be over-optimistic about the outcome of planned actions • This includes over-estimating the likelihood of positive events and under-estimating the likelihood of negative events • Results of driving skills self-assessment • 93% of US drivers and 69% of Swedish put themselves in the top 50% • For "ability to get on well with others", 85% put themselves in the top 50% and 25% in the top 1% • 87% of Stanford MBA students rated their academic performance as above the median • 68% of U. of Nebraska faculty rated themselves in the top 25% for teaching ability • M&A synergy estimates • Business plans, especially market entry, new product launches… SOURCE: Team analysis

6. Stability biases create a tendency toward inertia in the presence of uncertainty – for example anchoring Definition • Examples • Business applications • Anchoring makes people choose a figure close to a number (random or otherwise) that they have been presented with earlier • Kahneman & Tversky (1974) • Asked how many African Countries were in the UN, after a wheel of fortune was spun, people picked answers close to the wheel’s random output • Ariely (2003) • When anchored on their social security number, people with high numbers offer up to three times more to buy the same goods than people with lower numbers • Plous (1989) • When asked whether the odds of a nuclear war are greater or less than one percent most people picked ~10%. When asked if greater or less than 90% most people picked over 20% • Resource allocation between business units • Initial price setting in negotiations • Management of analyst expectations SOURCE: Team analysis

7. Social biases arise from the preference for harmony over conflict – for example groupthink Definition • Examples • Business applications • Members of a group striving for unanimity at the cost of realistic appraisal of alternative courses of action • Janus and Mann (1977) • Looked at decisions such as the Bay of Pigs versus the Cuban Missile crisis and uncovered evidence that poor decisions were made where the want for agreement overtakes the want for accuracy • Ahlfinger and Esser (2001) • Ran an experiment with promotional leaders (who promoted their own ideas) and non-promotional leaders. Promotional leaders caused more symptoms of groupthink, e.g. discussed fewer facts and reached decisions quicker than those without • “Attacker’s advantage”, i.e., innovations coming from smaller competitors vs. larger ones who should in theory have much larger resources • Importance of “corporate culture”, i.e., “the way we do things around here” in decision making • Frequent practice of orchestrating “pre-meetings” to arrive at a consensus before a decision meeting SOURCE: Team analysis

8. Interest biases emerge from conflicting incentives – for example misaligned personal incentives Definition • Examples • Business applications • Arise in the presence of conflicting incentives, including non–monetary and even purely emotional ones • Emotional attachment of individuals elements of the business (such as legacy products or brands) • Disagreements (often unspoken) about the relative weight of objectives pursued by the organization • Incentives for individuals to seek outcomes favorable to their unit or themselves, at the expense of the corporate interest, and to adopt views that further their interests • Research has shown that even well-intentioned professionals, such as doctors and auditors, are unable to prevent self-interest from biasing their judgments of which medicine to pres-cribe or opinion to give during an audit • When John Kennedy became U.S. president in 1961, one of the first decisions he faced was a plan to overthrow new Marxist regime in Cuba. The operation was launched in April 1961, but it was a disaster when the plan happened to be leaked. One of the elements of the failure was Kennedy’s self-interest bias. While he had personal misgivings about the whole enterprise, Kennedy was under domestic political pressure to do something about Cuba and was accused by opponents of being weak SOURCE: Team analysis

9. ‘Shooting from • the hip’– premature action before analysis completed (action-oriented and pattern recognition biases) • ‘Political • guesswork’– telling the CEO what it is assumed s/ he wants to hear (social and interest biases) • ‘Don’t rock the boat’– consensus based politics (stability, social, and interest biases) • ‘Dance as long as the music is playing’ – irrational exuberance (action, social, and interest biases) • ‘We’re in it already’ – escalation of commitment (pattern, social, and stability biases) • ‘Stuck in a rut’– extremely slow response to altered environment, (pattern and stability biases) • ‘Me too!’– tendency to unthinking follow the herd, (pattern and action biases) • ‘Old is gold’– excessive emphasis on experience and primacy (pattern and stability biases) • ‘Roadkill’– unswaying personal commitment to a decision leads to disaster, (interest and stability biases) • ‘Blindsided’– lack of competitor awareness when taking action, (social and action biases) • ‘Risk intolerance’– fear of failure leads to rejection of potential opportunities, (stability and interest biases) • ‘Planning fallacy’– tendency to underestimate the time, costs and risks of future actions while over-estimating the benefits of those actions (action-oriented biases) Additionally, biases sometimes combine to create typical patterns SOURCE: Team analysis

10. Why can’t we just correct our own biases? Self-awareness helps decision makers limit the effect of their own biases – up to a point Well-constructed decision processes can limit the effects of any individual’s biases SOURCE: Team analysis

11. We recommend five de-biasing principles CHANGING THE ANGLE OF VISION SHAKINGTHINGS UP RECOGNIZING UNCERTAINTY ENCOURAGING DEPERSONALIZEDDEBATE ENSURING TRANSPARENCY SOURCE: Team analysis

12. CHANGING THE ANGLE OF VISION Dozens of practical de-biasing techniques can be implemented against decision biases (1/5) “ • Competitive role play • Deep dives in business • Mind opening visits; extensive field visits • Comparison case analysis • Reframing • Formal capability assessment • Role reversal • Peer to peer interaction • Periphery scans • Personal board of advisors or external experts • Fast rotation of strategy team • Surprise reports • On reframing the decision… • The biggest dangers to a company are the ones you don’t see coming. Understanding these threats – and anticipating opportunities – requires strong • peripheral vision. It is very important to occasionally reframe your decision by applying a fresh angle of vision • Paul Schoemaker • Academic researcher and author in strategic decision making “ SOURCE: Team analysis

13. SHAKING THINGS UP Dozens of practical de-biasing techniques can be implemented against decision biases (2/5) “ • On avoiding the sunk-cost trap… • If the penalties for making a decision that leads to an unfavorable outcome are overly severe, managers will be motivated to let failed projects drag on endlessly – in the vain hope that they’ll somehow be able to transform them into successes. Don’t cultivate a failure-fearing culture that leads • Zero-based allocations • Contingent roadmaps • Marginal analysis • Reframing the problem/decision • Expectations reset • Decision group recomposition • Cross-functional / Cross-BU analysis teams • Closed file reviews • employees to perpetuate their mistakes. Shake responsibilities when necessary. • Ralph L. Keeney • Research Professor, Duke university • Co-Author of book “Smart Choices” “ SOURCE: Team analysis

14. ENSURING TRANSPARENCY Dozens of practical de-biasing techniques can be implemented against decision biases (3/5) “ • On incentives & transparency… • When stock is the currency being contemplated in an acquisition and when directors are hearing from an advisor, it appears to me that there is only one way to get a rational and balanced discussion. Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through. Absent • Explicit technical & nontechnical criteria • Quantitative decision preparation • Incentive alignment • Information sharing • Business logic test • Escalation of decision • this drastic remedy, our • recommendation • in respect to the use of advisors • remains. Don’t ask the barber whether you need a haircut..! • Warren Buffet • CEO, Berkshire Hathaway “ SOURCE: Team analysis

15. RECOGNIZING UNCERTAINTY Dozens of practical de-biasing techniques can be implemented against decision biases (4/5) “ • On avoiding over-optimism… • By supplementing traditional forecasting processes, which tend to focus on a company’s own capabilities, experiences, and expectations, with a simple statistical analysis of analogous efforts completed earlier, executives can gain a much more accurate understanding of a project’s likely outcome. Such an outside view provides a reality check on the more • Multiple scenarios • Mandatory alternative proposal • Contingent planning • Reference-based forecasting • Portfolio of decisions • Collective intelligence, e.g. prediction markets • Explicit risk and uncertainty calculations • Informal networks • intuitive inside view, reducing the odds that a company will rush blindly into a disastrous investment of money and time • Daniel Kahneman • Psychologist and Nobel Economics laureate “ SOURCE: Team analysis

16. Eric Schmidt • CEO, Google ENCOURAGING DEPERSONALIZED DEBATE Dozens of practical de-biasing techniques can be implemented against decision biases (5/5) “ • On encouraging debate… • You have to have dissent. If you don't have dissent then you have a king. And the new model of governance is very much counter to that. What I try to do in meetings is to find the people who have not spoken, who often are the ones who are afraid to speak out, but have a dissenting opinion. I get them • Red team / Blue team • Ad-hoc independent review • Comparison case review • Outsider challenge • Outside confirmation • Silent decision-maker • Quasi-peer group discussion • Devil’s advocate • Framing and reframing • Diversity in decision-making • Discouraging advocacy • Written commitment • Use of consensor • Rules of engagement • Hear everyone out, starting with juniors • Countercultural agenda setting • to say what they really think and that promotes discussion, and the right thing happens “ SOURCE: Team analysis

17. Distortions and deceptions in strategic decisions • D. Lovallo, O. Sibony • The case for behavioral strategy • D. Lovallo, • O. Sibony • How companies make good decisions • P. Viguerie, D. Lovallo • Beating the odds in market entry • J. Horn, D. Lovallo, P. Viguerie • Hidden flaws in Strategy • C. Roxburgh • Learning to let go • J. Horn, D. Lovallo, P. Viguerie • Delusions of Success– D. Lovallo and D. Kahneman • Deals Without Delusions– D. Lovallo, P. Viguerie, R. Uhlaner and J. Horn • The Hidden Traps in Decision Making– J. S. Hammond, R. L. Keeney, and H. Raiffa • Why Good Leaders Make Bad Decisions – S. Finkelstein, J. Whitehead, and A. Campbell • Emotional tagging –S. Finkelstein, J. Whitehead, and A. Campbell Delusion and Deception in Large Infrastructure Projects D. Lovallo, B. Flyvbjerg, M. Garbuio Several good informative and easily digestible articles are available • Articles SOURCE: Team analysis

18. And if you have more time, many ‘bestsellers’ are available • Nudge: Improving Decisions About Health, Wealth, and Happiness1 • Richard Thaler • Cass Sunstein • Predictably Irrational: The Hidden Forces That Shape Our Decisions1 • Dan Ariely • Judgment in Managerial Decision Making1 • Max H. Bazerman Don A. Moore • Driven: How Human Nature Shapes Our Choices • Paul Lawrence Nitin Nohria • Sway: The Irresistible Pull of Irrational Behavior • Ori Brafman • Rom Brafman • Risk: The Science and Politics of Fear • Dan Gardner • Books • Choices, • Values, and Frames • Daniel Kahneman Amos Tversky • Influence: The Psychology of Persuasion • Robert B. Cialdini • Think Again: Why Good Leaders Make Bad Decisions • S. Finkelstein • J. Whitehead • A. Campbell SOURCE: Team analysis