Irrational Exuberance?

Irrational Exuberance?

Judy Olian

(Judy Olian is Dean of Penn State's Smeal College of Business and a leading expert in strategic human resources management.)

Great leaders inspire and draw their followers into their wake with contagious enthusiasm. When times are tough, they buck up their spirits. Their charisma inspires a vision and encourages others to stretch beyond their natural limits. The leader's optimism and rose-colored glasses accelerate the forward momentum, but are they a source of danger?

Yes, according to an article in July's Harvard Business Review by consultant Dan Lovallo and Professor Daniel Kahneman, the 2002 Nobel Prize winner in Economics. Kahneman and his colleague, Amos Tversky, both behavioral statisticians, developed a framework called Prospect Theory, noting the paradoxes that emerge when statistical theory meets human behavior. They expected managers and executives to exemplify rational information processing, making decisions driven by facts and probabilities. To their amazement, over a long series of experiments, they observed that smart people make strangely irrational choices.

Lovallo and Kahneman provide several examples of judgment biases. We are all residents of Lake Wobegon. People exaggerate their own skills—70 percent of us delude ourselves into believing we are "above average." Only 2 percent admit to being "below average." When managers are given data on averages, say the average duration of a construction project, a software conversion, a product launch, or stock return, the majority of individuals discount the average and confidently predict they can beat the odds.

We tend to overestimate the extent of control we have over events, and underestimate the impact of luck and serendipity. When managers get lucky, they ascribe it to their own actions. Luck comes into play only when things go bad.

Another error in judgment is that we tend to be overly influenced by the opening bid. Kahneman calls this anchoring. When negotiating a contract, the first offer becomes the anchor no matter how random or unrealistic. Subsequent discussions are tethered to the anchor, moving up or down from there. Even if reasoned arguments and research are brought to the table, the initial bid exerts undue influence. And because we tend to exaggerate the positive, the anchor case is usually overly optimistic.

Kahneman and his colleagues observed that managers discount the prowess of competitors, and overestimate their own internal capabilities. They neglect the dangers of competition in new product launches, sustainability of market share, or forecasts of financial returns.

There's the problem of group think, where the team converges around the best case for a new venture, setting stretch goals. Many organizational cultures disdain modest goals and ostracize the nay Sayers. In a machismo climate, peers compete with each other to set outrageous targets. Under the pressure of trying to meet unrealistic targets, especially when linked to compensation, employees make rash judgments and take irresponsible risks.

The bottom line: We're usually more optimistic and ambitious than the data warrant. When planning under uncertainty, we overestimate expected benefits, and downplay the likelihood or costs of failure. We're focused excessively on our internal capabilities, and discount the power of rivals. We're overly confident in our capacity to control events.

That said, there are clearly benefits to seeing the world through rose-tinted glasses. Optimism is an important rallying device for leaders, and America would be less innovative without the delusion of success among entrepreneurs. But it also carries danger when it leads to faulty planning that then drives excess risk in execution strategies.

Lovallo and Kahneman suggest strategies to temper unsupportable optimism. Instead of an internally focused approach to planning, they advocate an outside driven approach. Collecting data from other companies or divisions that have engaged in similar projects clarifies the average project duration, on-time performance, rate of return, or product market share. Rather than discounting the experience of others, these benchmarks or reference classes should be used as the basis for forecasting uncertain business outcomes, especially when attempting a new business activity. And executives should reinforce a range of opinions, including those that shoot holes through exuberant forecasts.

When estimates exceed precedents derived from outside organizations, it begs the question "why do we think we can do better than our competitors?" Better than average projections are supportable only if there are known factors that distinguish the current situation, project, or team from these reference classes. Otherwise, the external precedents are the most objective and robust basis for the forecasts, rather than the group's subjective fantasies about its winning powers.

OK, this may sound like throwing cold water over gushing enthusiasm. Nothing against optimism—it's critical in the right place. However, exaggerated optimism in planning carries ominous business risks. Forecasts should be cold and calculating using the best outside data. But once plans are in place, contagious optimism can inspire the team to new heights, encouraging extraordinary efforts to achieve the goals. And there's nothing more inspiring than meeting goals, assuming they're realistic.

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