Decision Strategy – chapter 6

You are twice as excited about losing something as you are about gaining the same thing

If there is a 50-50 chance that something can go wrong, then 9 times out of ten it will.

Paul Harvey

In the 1980s, Coca-Cola CEO Robert Goizueta was deeply concerned about the future. Had time run out from Coca-Cola that Dr. John Pemberton back in 1886 had brewed together in his three-legged brass pot? In recent years, Coca-Cola had lost significant ground to arch-rival Pepsi despite Coca-Cola had much broader distribution and spent at least $100 million more annually on marketing. At this difficult time, Pepsi was smearing salt in Coca-Cola’s wounds with its national TV commercials, the Pepsi Challenge, where in a blind test dedicated Cola drinkers always preferred Pepsi. Coca-Cola’s immediate reaction to the Pepsi Challenge commercials was blatantly rejecting the results in public, but the internal concern was growing.

Coca-Cola’s mystery had always been about the famous secret recipe that had not changed in 99 years since Dr. Pemberton developed it. In a world where it was customary to change popular products to “new and improved” versions, the unique thing about Coca-Cola was that it was never new. But Goizueta was not called “President of Change” for nothing. Early in his tenure, he promised that there would be “no sacred cows including the recipe for our products.” He began to shake up the company’s traditions and introduced Diet Coke, Cherry Coke and more. Now Coca-Cola embarked on systematic market research that confirmed the Pepsi blind tests and Coca-Cola scientists began fiddling with the legendary secret recipe, making it more like Pepsi. Instantly, Coca-Cola’s market researchers saw improvements in the blind tests.

In September 1984, they tested what ended up being the final version of New Coke followed by one of the most expensive market research studies in history including 200,000 blind tests across North America. Here, New Coke beat Pepsi by 6-8 percentage points with only 10-12 percent of the taste test participants strongly opposed to changing the Coca-Cola recipe, so Goizueta gave the green light. In the launch press conference, Goizueta called New Coke “the safest move the company had ever made.” Yet New Coke became a disaster. Angry Cola drinkers demonstrated throughout the United States and began hoarding boxes of the old cola. A black market for Old Coke emerged, where a box went for $ 30 and more began to find ways to import it from abroad. Coca-Cola customer service received over 60,000 angry calls from Cola drinkers, while a group of Cola drinkers in the United States sued Coca-Cola. Their reasoning was that “when [Coca-Cola] took Old Coke off the market, they violated my freedom of choice. It is as basic as the Magna Charta, the Declaration of Independence. We went to war in Japan to defend this freedom”. Just 79 days after launch Goizueta was forced to withdraw New Coke and reintroduce the original recipe as “Coca-Cola Classic”. Despite an inferior product Coca Cola is still the dominant soft drink in the world and this marketing blunder of the century shows how difficult it is to understand what people actually think.

Loss aversion – prefer to avoid loss over gain

From the stocks we invest in over the projects we own to the special variety of Coke that we always drank; once we have something, we value it much higher than we did when we first encountered it regardless of objective value. It is called the ownership effect bias and stems from loss aversion, first publicized about 30 years ago by Richard Thaler in the bestseller “Nudge” and subsequently recorded in hundreds of studies. In the most famous, Daniel Kahneman conducted a simple experiment, where students’ incentive to swap two identically priced products was tested. One group was given a coffee cup, while the other group was given a chocolate bar, where after each group was offered the opportunity to swap with the other. Before receiving one or the other, about half had preferred the coffee cup and half preferred the chocolate bar, but now only 10% of each group was willing to swap their newly acquired product. The ownership effect means that after having received something – however temporary it may be – we attach ourselves to it and protest against changes that threaten to remove it. For example, marketers know that it takes oceans of work and money to get people to try something new even if it is better – let alone change their habit. In that context, the whole idea of a Pepsi versus Coca-Cola blind test gets a little silly, because no one drinks their Coca-Cola blind.

But how could Coca-Cola’s extensive research overlook the information they had right under their noses? This is because of the way in which losses affect our judgment. Let’s say you are faced with a choice. You can get 1 million kroner now, or you can get a 50-50 chance to win 2 million kroner or nothing. Which one do you choose? Most of us have a preference for a sure win rather than a bigger but more uncertain reward. But conversely, if you get the choice between definitely losing 10,000 kroner – or a 50-50 chance of losing 20,000 kroner or nothing, then most people will actually take the chance despite the potentially bigger loss. This phenomenon is known as loss aversion, which was originally described in Daniel Kahneman and Amos Tversky’s landmark article from 1979, The Prospect Theory. When Coca Cola faced losing its market position, they bet big. But would they have shown the same willingness to take risks at the prospect of a gain? 99 years of history where Coca-Cola dominated the soda market without making a single change in their recipe indicates that they probably would not. In fact people are about twice as loss averse as they are attracted to the same gain, but that is not all – loss aversion is a group of several biases:

Ownership effects – my house is above market

Also known as divestment aversion we attribute more value to things simply because we own them, as seen above. Most people in the business world have already seen the light in the ownership effect when it comes to enticing you to buy their products. For example, when you buy a computer from Dell, you get a 90-day trial period on an anti-virus program from Norton. This means that we as a computer user are more likely to purchase the software at the end of the free trial period than if it were not offered. The ownership effect will be further strengthened if we at the same time put a lot of energy into making the project into something – also known as the “IKEA effect”. In a variety of experiments, participants were set to assemble IKEA products or build things from Lego, after which they felt that their amateur projects had similar value as if they were made by experts.

Framing effects – 90% fat free trumps 10% fat

People react to a particular choice in different ways depending on how the choice is presented; as a loss or as a gain. People tend to avoid risk when a positive framework is presented, but seek risks when a negative framework is presented. For example, it feels mentally more dramatic if you, as the leader of a merger, communicate “we unfortunately had to fire 30% of the employees” instead of “we succeeded in saving 70% of the jobs”. The math is basically the same, but the first sounds like a loss, the second like a win.

Sunk cost & escalate commitment – say no more

We tend to invest money, time and resources based on past investment decisions where we cannot get our investment back and which therefore should not be part of our decisions about the future. For example, if we have once invested in a startup, we will have an easier time investing a second, third and fourth time in the same company, as we do not want to risk our previous investment being “lost” – even if previous investments cannot be regained and thus should not enter into considerations about future investments. We escalate the commitment to our initial decision instead of changing course, even when we get more and more negative outcomes from continuing the course. It is related to sunk cost and occurs, for example, when we have chosen to engage time and resources in hiring an employee who turns out to be incompetent, a new factory that does not give the results we had hoped, or a new product that fails to perform as we had hoped.

Mental bookkeeping – easy come easy go

Also known as the two-pocket theory occurs when we place our money in separate categories or mental accounts, based on where the money comes from or what it is intended for. For example, every month we have allocated our salary to a number of fixed expenses and have a sober approach to our money, but if we suddenly get an unexpected windfall, we can just blow it off because it feels like a different kind of money. In fact, the adage “easy come easy go” is an example of this kind of mental bookkeeping.

Scarcity trap – last shirt is most valuable

When we experience scarcity – for example of time, money, relationships, calories – we tend to concentrate our thoughts on the scarce good – something that actually makes us better able to to assess what the good is worth. But it also means that we tend to become short-sighted, weak-willed, and get tunnel vision because we spend so much mental bandwidth dealing with our thoughts about this scarce resource that we have less mental IQ for other important decisions. Marketing experts work to match supply to demand, but by using the illusion of scarcity, they can accelerate demand. Excellent examples of this effect are the launch of iPhones or Harry Potter books, where the pre-launch was designed not only to increase demand but at the same time to create the illusion that supply would be limited. In many situations, the mere thought of scarcity can actually reduce our intelligence significantly. In several tests among shoppers in shopping malls in the United States and in the fields of Bangladesh, participants were asked about their income and then discreetly classified as either poor or rich. Then they were asked the question: “Your car needs a repair. The insurance covers $150, but it will cost you $150 in deductible. You can choose to take out a loan, pay in full or defer service. What do you choose?” After the test subjects had the answer, they had their fluid intelligence and self-control measured in a Raven test. When it was only about $150, the poor and rich did just as well on the intelligence and self-control test. But when the researchers changed $150 for the repair to $1,500, something significant happened: Rich participants passed the intelligence and self-control test just as well as before, but poor participants did not. The mere thought of facing a $1,500 extra expense put so much pressure on their bandwidth that their floating intelligence score dropped 13-14 IQ percentage points. To put it in perspective, a loss of 13 IQ points can move you from ‘normal intelligent’ to the category of ‘deficient’ or the 5-7 percent least intelligent in society.

6S model – think expected benefits

A simple but effective rule for optimized decisions is that we should always base our decision on the option with the highest expected benefit. In economics, game theory and decision theory, the expected utility hypothesis is a theory of people’s preferences when faced with choices with uncertain outcomes, i.e. bets. You arrive at the expected benefit of an uncertain choice by multiplying the expected outcome of the choice by its probability. The expected benefit model says that 1 million kroner is worth twice as much and provides twice as much benefit as 500,000 kroner. On paper, it seems very true, but people do not feel twice as much pleasure from a gain that is twice as great. This is due to the “declining marginal utility of gains”, which means that the more we get from something, the less joy it gives us. As this is unnatural to us, it should be incorporated in the organization’s levers – here are some examples:

Strategy: We might be tempted to believe that strategy in the risk-averse organization will be the opposite of the over-optimistic one. But risk aversion is not a bias. It is a risk preference that is not about ‘overcoming’ our propensity, but instead comparing value and risks at different options so that we do not stumble into the accompanying biases such as framing, ownership effect, etc. A good place to start strategy analysis is to move beyond the expected scenario and include both best/worst-case scenarios and Wild Cards in the analysis, so that they get a thorough processing and not just “analyzed” superficially in the risk averse leader’s head. A later important step is to go into detail with the Playing to Win strategy, where you investigate how you can win on the game board you are betting on – and not least what it requires of you as an organization. It can also take the form of a series of high risk/high return investment projects versus some low risk/low return investment projects, as long as the options are easy to compare on relatively objective criteria.

Systems: One of the things that can go really wrong here is the feeling of insecurity that leads us to constantly seek more information to be completely sure of the decision. It is difficult to predict the future, so at some point the analysis must stop and the management must show why it is there. If this approach with more and more information is allowed to slip into system design, then you are quickly faced with a very complex and heavy system that pulls the energy completely out of the organization. Therefore, it is important to think simplification and reduce information retrieval to the absolutely critical issues as well as maintain this approach over the time the system is developed.

Skills: In risk-averse organizations it can be difficult to attract people with the opposite approach, but that is exactly what you need: inspiration from creative thinkers, innovators and entrepreneurs as well as over-optimistic people from e.g. the management of role model and innovative companies in similar industries. It will be like getting a necessary vitamin injection and giving your organization a significant boost for a period of time. To make the period last, you can start by getting these people in for inspiration workshops, later for longer strategy projects and finally in protected units – in the same way as when you want to establish a business unit that is very different from the core business. When you are ready, put the protected unit together with the core business.

This was the abbreviated version of chapter 6 in our awarded book Decision Strategy. Next week we will focus on emotional biases – maybe the most challenging of all the bias groups. If you cant wait… contact or +45-23103206.

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