Mike Lehr's Blog

The research behind behavioral economics is full of emotional solutions to everyday problems. By tapping into the emotional biases behind our decisions, we can expand the range of limited solutions offered by rational thought models. The exploring of emotional solutions has gone big time as the article, “Nudge Nudge, Think Think” explains in the March 24, 2012 edition of The Economist by focusing on the amount of investments governments are making in this area.

Said simply, “How we phrase things matter.” I’ve written how this can change the taste of food and even change the reactions to a bonus plan. As the article explains, nudging “shows it is possible to steer people towards better decisions by presenting choices in different ways.”

For example:

• People were three times more likely to pay an outstanding vehicular tax when the letter was simplified and included a picture of the automobile.
• Boys did better than girls did when a technical drawing class was called “geometry,” and girls did equally well or better when it was called “drawing.”
• People were more inclined to use less energy when their consumption was compared to their neighbors.

Not only does this help us solve problems, it also helps us avoid them by being aware of what we say so we don’t sabotage our well-intentioned plans. Choosing the right words for a personality can go a long way in helping us to effect the change we desire by tapping the right emotions.

For example, my wife won a bet at a party by talking a friend’s six-year-old daughter into selecting a vegetable over chocolate to eat. Understanding and appreciating the power behind words’ connotations helps us immensely here, and Roget’s Thesaurus is invaluable in our efforts.

Remember, people eat escargot not snails.

Emotions drive human decision-making, a key assumption behind the effectiveness of intuitive approaches. However, mainstream economic theory – as represented by neoclassical economics which most of us learned in college and business school – is rooted in the belief that humans arrive at decisions through a rational process incorporating logic and reason.

Recently though, the work of Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School on the momentum effect in financial markets challenges investors’ rationality. Their work reinforces a more contemporary theory, behavioral economics, which incorporates emotions’ in financial decisions.

As mentioned in the article, Why Newton Was Wrong, published in the January 8, 2011 edition of The Economist, the momentum effect says we can successfully invest in financial markets by looking at a stock’s recent performance. There is little need for fundamental analysis of the company to determine its intrinsic value. That is because stocks that went up in the recent twelve months are likely to continue to go up and vice versa.

The momentum effect challenges conventional wisdom, more specifically the efficient market hypothesis (EMH) which assumes investors are rational. It claims that investors can’t logically gain an advantage by looking at past performances; a stock that is going down is just as likely to go up as one that is already going up.

Emotionally, investors like winners. They believe rising stocks will continue upward. Consequently, they buy more. Their beliefs become reality because many investors do the same. Objective stock value is relatively immaterial compared to momentum. This helps to explain how economic bubbles (i.e. tech stocks, housing) form.

Appreciating the emotions behind investing, helps us realize that efficient markets are nothing more than rational mirages. The same holds true for virtually every human decision.

More detail on the momentum effect: Financial Times article and ABN-AMRO Report (pdf containing charts and graphs)

The article, The Case for Behavioral Strategy, (PDF) by Dan Lovallo and Olivier Sibony* from the March 2010 McKinsey Quarterly states:

Once heretical, behavioral economics is now mainstream. . . . Yet very few corporate strategists making important decisions consciously take into account the cognitive biases—systematic tendencies to deviate from rational calculations—revealed by behavioral economics. . . . in strategic decision making leaders need to recognize their own biases.

As I pointed out in my postings regarding the difference between leadership and management and confidence as an indicator of incompetence, advancements in technology and research methodologies are increasingly showing the influence of unconscious biases in our decisions. Our unawareness encourages substandard decisions. Learning our biases and accounting for them is important. Here are a few common biases mentioned in this article:

• Believing good analysis by managers with good judgment will automatically lead to good decisions
• Over-weighting recent or highly memorable events
• Clinging to a formed hypothesis even when there is evidence disproving it
• Taking actions prompted by excessive optimism and overestimation of our abilities
• Endorsing projects proposed by confident advocates over those who identify all the risks and uncertainties
• Over-weighting last year’s numbers in budget reviews
• Feeling losses more intensely than equivalent gains
• Underestimating the influence a person’s self-interest has in his determination of what’s best for the group
• Conforming to the dominant views of the group or its leader

Among the article’s solutions were:

• Establish formal decision making processes
• Take a different perspective and form alternative hypotheses around it
• Examine at least six similar experiences, not just one or two
• Identify uncertainties and unknowns in planning
• Redo budgets from scratch rather than from last year
• Encourage diversity and dissent

*Olivier Sibony is a director in McKinsey’s Brussels office.

On the Harvard Business Review site, I read the posting “True Leaders Are Also Managers” by Robert I. Sutton, Professor of Management Science and Engineering at Stanford’s Graduate School of Business. He commented, “I kept bumping into an old and popular distinction that has always bugged me: leading versus managing.” While I liked his main point linking good leadership to good management, he didn’t resolve the intuitive deficiencies I find in academic attempts to make a distinction between the two.

Figure 1: Good Leadership is Based Upon Good Management 

First, they overlook that leadership is an affect: an emotion in the follower producing an affinity for the leader. The subjective and personal nature of leadership is clearly expressed when we consider that we can manage things such as resources, investments and processes but we can only lead people. This affect transforms management into leadership, metaphorically in the same way we turn a house into a home. Figure 1 expresses the dependent nature of leadership on management as suggested by Professor Sutton. Thus, the difference between leading and managing is emotional.

Figure 2: Change Difference between Leadership & Management  

Second, academia tends to overlook that leadership is about change. It’s derived from lead which implies motion and in turn change – moving from one point to another. As Figure 2 shows, the greater degree of change we require, the more important leadership becomes; good management alone likely won’t be enough. For instance, we don’t say “They’re managing a revolution (extreme change),” we tend to say, “Leading a revolution.” When others respond to how they’re doing with “I’m managing” it implies “keeping up” or “going with the flow.” It doesn’t come close to implying any dynamic attempt of effecting change.

Just as economics is being transformed by behavioral economics, those same psychological influences need to begin transforming an impractical, out-dated, academic perspective of leadership.

Other links in this series:

• Leadership vs. Management: The Difference (Part II)
• Leadership vs. Management: The Difference (Part III)
• Leadership vs. Management: The Difference (Part IV)
• Leadership vs. Management: The Difference (Part V)
• Leadership vs. Management: The Difference (Part VI)

In the article, “Are You Being Served?”, in the September 6, 2010 issue of The New Yorker, the author James Surowiecki cites a survey of more than three hundred big companies from a few years ago in which “eighty per cent described themselves as delivering ‘superior’ service, but consumers put that figure at just eight per cent.”

Yet, one of the assumptions implied in the article is that quality service matters to the customer, or at minimum it should. Yes, in an open-ended request, customers would say that is does. However, how much are they willing to pay for it? Furthermore, will they actually pay for it when the opportunity arises? The article did cite some companies providing good service for low cost; however, it could only offer up luxury businesses as examples of where good service could support a cost premium. Of course, in these cases we have to factor in the emotional effects of buying something that conveys status; here, branding is vital.

In the end, there might not be an objective answer to the question. It depends upon many factors such as the consumer, the market, the competition, the product, the brand and the buying experience itself. For example, the article never concerned itself with product quality. Perhaps some consumers are willing to tolerate poor service if the product is top-notch. That becomes an issue of value which is subjective and thus emotional.

The unresolved question implied by the study was, “Why do customers tolerate such a discrepancy and not move to another provider?” However, the author overwhelmingly focused on why businesses don’t provide quality service and didn’t explore this intuitive phenomenon.