When it comes to making decisions, human beings have built-in biases. So do companies and other organizations. In any number of ways, these biases can stall, skew, or deny the kind of clear-sighted decisions that are at the heart of strategic management. To effectively tie strategy to value creation, management should make tangible efforts to overcome these biases.
The late Nobel Prize–winning psychologist and economist Daniel Kahneman laid the foundation for what we now call behavioral economics and behavioral finance. While his focus was primarily on individual decision-making, we had the opportunity to ask how it might apply to organizations. We asked him, “If people don’t behave in an economically rational way, is there any hope for organizations?” His response: “I’m much more optimistic about organizations than individuals. Organizations can put systems in place to help them.” Managers can develop rules and processes that help overcome inherent decision-making biases.
Drawing on Kahneman’s insights, a group of McKinsey colleagues has proposed (or adopted from others) a number of techniques to help organizations understand and improve their decision-making in resource allocation. In this article, we discuss four common biases that can affect organizational decision-making, along with some potential remedies.
1. Groupthink
Groups of decision-makers tend to engage in groupthink, an overemphasis on harmony and consensus. This can get in the way of examining all the options objectively, leading to weaker—and sometimes disastrous—decisions. Arthur Schlesinger Jr., one of President John F. Kennedy’s advisers, wrote this about his participation in the debate over the Bay of Pigs invasion of Cuba, which failed: “In the months after . . . I bitterly reproached myself for having kept so silent in the Cabinet Room. . . .”
A variation of this bias occurs when participants don’t speak up because they feel the subject under discussion does not fall under their area of responsibility or expertise. At one global agriculture company, executive committee members tended to speak up during strategy conversations only if their business areas were being discussed. The tacit assumption was that colleagues wouldn’t intrude on other colleagues’ areas of responsibility—an assumption that deprived the committee of their insights.
The weight of evidence strongly supports that decisions are better when there is rigorous debate. One research effort found that for big-bet decisions, high-quality debate led to decisions that were 2.3 times more likely to be successful. Extensive study has explored the importance of vigorous debate in improving decision-making.
Ideally, a company dedicated to pursuing long-term strategic success should have a culture of dissent where rigorous debate is the norm. But most companies need to take more active steps to stimulate debate. The key ingredient is to depersonalize debate and make it socially acceptable to be a contrarian. Here are some useful techniques:
- Assign a devil’s advocate. At a strategy discussion, assign someone the task of taking an opposing point of view. Make sure this contrarian’s contribution is more than just offering opinions. The focus should be on calling attention to potential alternate scenarios or highlighting missing information important to the debate.
- Bring diverse perspectives to the discussion. More than 150 years ago, John Stuart Mill wrote in On Liberty, “The only way in which a human being can make some approach to knowing the whole of a subject is by hearing what can be said about it by persons of every variety of opinion.” More recent research has proved his point. Diversity means drawing on the opinions of people from different disciplines, roles, genders, and races in important discussions. Bring in more junior people with special expertise, create an environment where it is safe for them to speak up, and ask them for ideas.
- Encourage debate with secret ballots. Use a secret ballot at the beginning of the debate, not the end. Once a proposal has been presented and before it is debated, ask participants to vote on the idea in secret. The request could be for a yes or no vote on a project or for a ranking of investment priorities. When the results are revealed, assuming participants discover at least one other person shares their views, the knowledge will likely make them more comfortable expressing their opinions.
- Set up a red team–blue team activity for large investments. Arrange two teams to prepare arguments for opposing outcomes. While undertaking the preparatory work and analysis for this approach is expensive, it can make a difference for particularly large decisions with high uncertainty.
2. Confirmation bias and excessive optimism
Confirmation bias and overoptimism are two distinct biases. However, the same set of techniques applies to both, so we discuss them together.
Confirmation bias is the tendency to look for evidence that supports your hypothesis or to interpret ambiguous data in a way that achieves the same result. For business decisions, this often takes the form of “I have a hunch that investing in X would create value. Therefore, let’s look for some supporting facts that will back up our hunch.” The universal foundation of the scientific approach to addressing a hypothesis is the opposite: You should look for disconfirming evidence.
Overoptimism is the tendency to assume that everything will go right with a project, even though past projects tell us that such smooth outcomes are rare. A classic example is the construction of the famous Sydney Opera House, whose schedule and budget were both overly optimistic. The project was completed ten years late and cost 14 times the original budget.
Some of the techniques used to overcome groupthink, such as the use of opposing red and blue teams, can help here. The simplest approaches are to avoid developing hypotheses too early in the process and to actively look for contrary evidence. Other potential correctives for confirmation bias and overoptimism include the following two methods:
- Conduct a premortem. A “premortem” is an exercise in which, after a project team has been briefed on a proposed plan, its members purposely imagine that the plan has failed. The very structure of a premortem makes it safe to identify problems.
- Take the outside view. Build a statistical view of a project based on a reference class of similar projects. For instance, a group at a private equity company was asked to build a forecast for an ongoing investment from the bottom up—tracing its path from beginning to end and noting the key steps, actions, and milestones required to meet proposed targets. The group was then asked to compare that ongoing investment with categories of similar investments, looking at factors such as relative quality of the investment and average return for an investment category. Using this outside view, the group saw that its median expected rate of return was more than double that of the most similar investments.
3. Inertia (stability bias)
Inertia, or stability bias, is the natural tendency of organizations to resist change. One study found that spending allocations across business units among the companies it studied were correlated by an average of more than 90 percent from year to year. In other words, the allocation of spending to business units essentially never changed. The same study showed that companies that reallocated more resources—the top third of the sample—earned, on average, 30 percent higher TSR annually than companies in the bottom third of the sample.
The solution to inertia bias is relatively straightforward. Rank initiatives across the entire enterprise by potential value creation. In addition, ensure that the budget you are building is rooted in the current strategic plan, not last year’s budget. The essential idea is to ignore the influences of past allocations or budgets as much as possible. In practice, you may be unable to shift resources as quickly or as much as you should. But trying to ignore the past is a starting point and will help you minimize inertia.
4. Loss aversion
Research shows that most executives are loss averse and unwilling to undertake risky projects with high estimated present values. The primary solution to overcoming loss aversion is to view investment decisions based not on their individual risk but on their contribution to the risk of the enterprise as a whole.
That’s easy in theory, but executives are typically concerned about the risk of their own projects and the potential impact on their careers. That’s why those decisions should be elevated to executives with a broader portfolio of projects whose risks cancel each other out. Often, the decisions must be pushed up to the CEO.
To be most effective, companies also should encourage middle-level managers and other employees to propose risky ideas. Companies can do this by eliminating risks to the employee. Many employees censor themselves because of concerns that their careers will suffer if their idea for a project fails. To overcome this concern, it’s important to agree on the various risks up front with the top leadership and conduct postmortems on projects, particularly to identify causes of failure. If a project fails because the decision to go ahead with the project turned out to be incorrect (which should happen frequently), that failure should not bear on the manager responsible for the project. The responsible manager should only be accountable for the quality of execution of the project.
Jeff Bezos, founder of Amazon, puts it this way: “I always point out that there are two different kinds of failure. There’s experimental failure—that’s the kind of failure you should be happy with—and there’s operational failure. We’ve built hundreds of fulfillment centers at Amazon over the years. . . . If we build a new fulfillment center and it’s a disaster, that’s just bad execution. That’s not good failure. But when we are developing a new product or service or experimenting in some way, and it doesn’t work, that’s OK. That’s great failure.”
Decision biases can prevent good ideas from turning into value-creating actions. The list of best practices for decision-making is long and can be daunting, but executives can begin by recognizing four foundational biases and taking time-tested steps to address them. Adding new refinements over time will move any company closer to the goal of managing strategically for the long term.
