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The Conference Board Review® Article
Money Changes Everything
Why we can’t see clearly when making economic decisions.
By James Krohe Jr.
James Krohe Jr. is a Chicago-area writer and editor. His most recent article was "Why Good Companies Still Get Sued," the July/August cover story.
To the shareholder he is a savior, to the business press a warlord. To most economists, however, the CEO of the large business is Homo economicus, the economic man envisioned by classical economics theory, a ruthlessly rational calculating machine geared to perceive what is in the interests of the firm and how to achieve it at least cost.
So much for theory. In few places is the myth of the rational economic man more mythic than the executive suite. We've made decision-making into a science, yet CEOs seem scarcely rational when making the tough calls involving economics.
Consider some of the familiar conundrums from the world of big business. According to the tenets of classical economics, top managers of large companies with multiple divisions should be acting as investors, evaluating business opportunities within the company and shifting capital among business units in order to fund the best opportunities. But that isn't the way most firms do it. The well-known tendency in multi-business firms is to allocate capital evenly across divisions, thus overinvesting in divisions with limited opportunities and cross-subsidizing poorly performing segments by better-performing ones. (This is especially the case in firms that are diversified across unrelated industries, where like-to-like comparisons are hard to make.)
Then there is the "winner's curse," the tendency of bidders at auctions -- including rival firms bidding to acquire a takeover target -- to end up paying too much. And the otherwise-savvy CEOs who hold on to loss-making business units well past their sell-by dates. And mergers that, on average, destroy rather than create value.
Why do executives presumed to be professional optimizers goof so often, and so expensively, in making decisions of economic import? According to the maturing science of economic psychology, those poor decisions are the result of unconscious biases that subvert otherwise-sound analysis of a deal. When it comes to economic decisions, what senior managers think matters less than how they think.
An Exaggerated Sense of Control
When the senior executive sits down to decide whether to buy A or sell B or sign off on X's proposed budget or shut down division Y or commit resources to product Z, she can't count on the intuition that got her to the corner office: The lesson of nearly thirty years of research into the psychology of economic decision-making is that the ways we feel about money -- having it, making it, losing it -- seldom add up. As hundreds of experiments since the 1970s have confirmed, we are haunted by the prospect of loss. Our perceptions are easily skewed according to how a problem is presented. We turn blind eyes to inconvenient facts. We draw big conclusions from samples too small to support them. We confuse economic cause and effect. We analyze problems in terms of what we remember, or what we fear, rather than what we might gain.
Some of these ingrained responses are emotional, some biological, some social, others cognitive. Whatever their origin, decision-making biases of the economic sort work deep in the subconscious. We are no more aware of the process than we are aware of our irises when they shrink in response to a flash of light. And they work whether we are contemplating buying a new car or a new car company.
The CEO of a large firm is uniquely vulnerable to decision-making biases about money. That's because he spends much of his time deciding big deals -- the mergers, the divestitures, the downsizings. Unfortunately, it's the biggest decisions that tend to involve the most assumptions, the most estimates, and the most inputs from the most people. In such situations, the best choice is not obvious, so we rely on gut feeling -- and gut feelings are the most prone to distortion.
Comments? Write a letter to the editor.
Return to the November/December 2007 The Conference Board Review® issue.
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