Richard Zeckhauser on improving decisions

Richard Zeckhauser, aka Mr Probability, was recently interviewed in Outlook Business. Zeckhauser is a champion Bridge player and the Frank Ramsey professor of political economy at Harvard University.

When asked how companies can prevent overpaying for acquisition, Zeckhauser responds:

There is this tremendous optimism bias built into acquisitions. Synergies in my experience are frequently overstated. If I were looking at a large merger, I would hire a team in my corporation to present arguments to the board as to why we should not do it. The idea is to have a countervailing team to poke holes in the logic. Organisations have this tremendous tendency to get behind the boss and do what he thinks should be done, but you have to get away from that and motivate people to bring to the table something contrary to what is being said.

That bit of wisdom applies to more than just corporate acquisitions.

The problem, as Zeckhauser points out, is that people often blindly follow the boss and what s/he thinks should be done.

Stanley Milgram demonstrated our obedience to authority through a series of experiments. Milgram summarized his most famous experiment in a 1974 article, The Perils of Obedience, writing:

I set up a simple experiment at Yale University to test how much pain an ordinary citizen would inflict on another person simply because he was ordered to by an experimental scientist. Stark authority was pitted against the subjects’ [participants'] strongest moral imperatives against hurting others, and, with the subjects’ [participants'] ears ringing with the screams of the victims, authority won more often than not. The extreme willingness of adults to go to almost any lengths on the command of an authority constitutes the chief finding of the study and the fact most urgently demanding explanation.

Ordinary people, simply doing their jobs, and without any particular hostility on their part, can become agents in a terrible destructive process. Moreover, even when the destructive effects of their work become patently clear, and they are asked to carry out actions incompatible with fundamental standards of morality, relatively few people have the resources needed to resist authority

Zeckhauser was also asked how we can make better decisions.

One part of decision-making is about how to place your priorities. Let me tell you what I said to a group of investment professionals recently. They were making investments and were being introduced to five fund managers. I said, “You have $50 million to invest and you have five potential managers; that does not mean you have to give $10 million to each of these managers. If you really think that manager A is much better, you should probably give him 25 and the others much smaller amounts.” Then, you improve your odds.

Here’s another example out of what I see in everyday life. You get 50 e-mails during the day and you answer 30 of them. On the one that you answer the most, you take 3 minutes. In all the others, you take 45 seconds. You should take 25 minutes to answer the one that is important, but you don’t. Once that is pointed out to you, you will say that is really obvious. In other words, you should decide what is really important and make your choices accordingly.

The other thing is about distinguishing between various probabilities. I think of making decisions the way I play tennis. I have taken many tennis lessons and my trainer always tells me the same three or four things. Keep your eye on the ball, get into position, swing your racquet back and swing the ball. I pay him $75 to tell me “keep your eye on the ball” and he tells me the same thing over and over again because the natural tendency when you are playing tennis is to take your eye off the ball. The natural tendency when you are thinking about probabilistic situations is to marginalise probabilities — treat 1%, 5%, 10% and 15% probabilities all as low probabilities. I think it is worth your while before you take a decision to figure out whether it is going to be 1%, 5%, 10% or 20%. And when it is worthwhile and when it is not. But most people don’t bother to do that.

I am writing a paper today where we start off talking about President Obama’s assessment of the likelihood that Osama bin Laden was in the hideout where we found him to be. He had a variety of assessments and he eventually concluded well it was 50% likely that we were going to go get him. Now, there is nothing magical about 50%. It might be that it is perfectly worthwhile to go and raid that compound if the probability is only 30%. And maybe it is not worthwhile even if it is 70%. Think about that. But people feel that 50% is magical and they don’t like to do things where they don’t have 50% odds. I know that is not a good idea, so I am willing to make some bets where you say it is 20% likely to work but you get a big pay-off if it works, and only has a small cost if it does not. I will take that gamble. Most successful investments in new companies are where the odds are against you but, if you succeed, you will succeed in a big way.

Zeckhauser recommends reading Thinking, Fast and Slow to improve your ability to make better decisions and think probabilistically. If you’re looking for something less mainstream but equally insightful try Max Bazerman’s Judgment in Managerial Decision Making, which has been a favorite of mine for years.

Still curious? Zeckhauser is the author of a fascinating paper: Investing in the Unknown and Unknowable.