If introducing a new product line creates a small probability of losing a few million dollars and a large probability of earning many billions of dollars, it seems clear that the new product line should be introduced. But does what we know about managerial decision making suggest that the new product line will be introduced? Unfortunately, a great deal of research suggests that many decisions involving uncertainty go awry. It appears that people make systematic errors in reacting to the probability of events. In particular, decision makers may exaggerate the importance of small probabilities, understate the importance of large probabilities, and are generally insensitive to changes in probability that fall between those two extremes.
In recent research, Money, Kisses and Electric Shocks: On the Affective Psychology of Risk, Christopher Hsee and Yuval Rottenstreich at the University of Chicago?s Booth School of Business find that this pattern of exaggeration, understatement and intermediate insensitivity is especially pronounced when the outcomes of a decision are emotionally charged?as they so often are in crucial business decisions. An exaggeration of the small probability of a loss and an understatement of the large probability of a gain may inappropriately discourage a manager from making an important decision, such as launching a new product line. Similarly, understating the large probability of overestimating synergies in a merger may lead managers to pursue them despite the odds being stacked against them.
What?s to be done? As a first step, organisations need to recognise when emotions influence decisions. There are two key steps in the managerial decision making process. First, managers must thoroughly research and accurately assess the likelihood of various possibilities. Second, managers must properly and expertly apply their knowledge. Then, the key is to separate the two steps of decision making. Mid-level managers in a firm should be charged with the task of assessing the likelihood of success and failure. Senior management and the board of directors should be responsible for making decisions based on the given assessments.
This sort of separation makes it more likely that the person who makes the final decision will be emotionally detached from the outcome and will react rationally to the relevant probabilities. Only then can a firm ensure that decisions are made in a more rational and calculated way.
Human errors in reacting to the probability of an event can be explained thus: one famous study found that the typical person was indifferent between receiving a 1% chance of winning $200 and receiving $10 without doubt, and was also indifferent between receiving a 99% chance of winning $200 and receiving $188 for certain. That is, people reacted to probabilities in a way that made the first hundredth of probability worth $10, the last hundredth worth $12, but the ninety-eight intermediate hundredths worth only $178, or about $1.80 per hundredth.
The impact of the small 1% probability is even more exaggerated when emotions come into play. In an experiment conducted by the authors, a group of students imagined that they could receive either the opportunity to meet and kiss their favourite movie star or $50 in cash. Most preferred cash to a kiss. But when another group of students was asked to imagine that they could take part in either a lottery offering a 1% chance of winning the opportunity to meet and kiss their favourite movie star or a lottery offering a 1% chance of winning $50 in cash, most bet on the movie star. When making decisions, people are likely to react to the image and the effect conjured up by the relatively exciting and emotion-laden kiss when compared to the relatively pallid and emotion-free cash. When emotions are involved in decision making, people ignore the assessed likelihood of these possibilities.
Managers might grossly exaggerate the impact of small probabilities, grossly understate the impact of large probabilities, and be entirely insensitive to any probability variations. So when an executive is emotionally attached to the possible outcomes, the person who makes the final decision concerning the product line introduction may inappropriately ?ignore? the odds of success and the odds of failure. Instead of making a decision that is based solely on the judged likelihood of success, the manager may be swayed by emotional thoughts and affective images concerning how hard the company?s team has worked, or how thrilling it would be to read news detailing the success of the project.
A manager who erroneously reacts to these emotions rather than to the judged probability of success will treat every probability in the same way. As a result, the manager may be severely over-aggressive or severely under-aggressive when the probability of success is low. Organisational design that facilitates the tasks of assessing the probability of success and that of decision making can lead to less emotionally charged, more rational decision making.
The author is an assistant professor of finance at Emory University, Atlanta, and a visiting scholar at ISB, Hyderabad