The recent upsurge in mergers and acquisitions flies in the face of strong evidence showing that key decision makers’ are tricked into underestimating the risks to shareholder value and profit by their own overconfidence about the likelihood of success.
In August there was a surge in mergers and acquisitions activity (e.g. BHP Billiton’s bid for Potash, Intel’s for McAfee). Thompsons Reuters’ data show nearly $90 billion worth of deals in one week alone, making it the largest weekly total for 4 years. This activity flies in the face of evidence showing a surprising lack of success e.g. simply announcing merger bids wiped off over $220 billion from the share price of acquiring companies over the period 1980 – 2001 (Moeller, Schlingemann, and Stulz, 2005); at best there is only a 50/50 chance of success (McGee, Thomas and Wilson, 2005). In any other context these chances would be considered far too risky. So why do CEOs and organisations do it?
Evidence suggests that key decision makers are blinded by overconfidence, leading them to over-estimate their own chances of success. They know that many other organisations have failed but are confident about their own chances of making it work. However, research shows that they are, in fact, overconfident and just as likely to fail as other organisations. This overconfidence is due to the short-cuts in thinking (heuristics) decision makers use when faced with complex decisions. These short cuts are very useful because they make complicated problems simpler and easier to resolve. However, when simplifying in this way crucial information is neglected and this usually reduces the accuracy or appropriateness of the solution.
One important simplification strategy used by decision makers is confirmation thinking - a strong tendency to focus on information that supports an existing belief and ignore information that challenges it. This leads to a number of biases:
• Overconfidence – people hold beliefs with higher degree of confidence than they should because they fail to take account of the information challenging this belief. Research shows that CEO overconfidence is a major factor determining mergers and acquisitions – those initiating these activities are much more confident of success as compared with external experts and analysts and this level of confidence is much higher than the actual likelihood of success.
• Optimism – allied to overconfidence; decision makers have a general tendency to believe that, in comparisons to people similar to themselves, good things are more likely to occur to them and that bad things are less likely to occur.
These factors mean that CEO judgements of success of mergers and acquisitions are overly optimistic and downside risks overlooked so not addressed.
Can anything be done to rectify this situation and help CEOs and organisations make less biased decisions? Research shows that there are three ways of overcoming this problem:
• Better governance: evidence shows there is more merger and acquisition activity when CEOs also act as president and chairman of the board (Malmendier & Tate, 2008); this highlights the crucial role of weak oversight by boards of directors and the need for better governance.
• Train key decision makers to think smarter: people can be taught to think in ways that reduce overconfidence.
• Better decision making processes e.g. use of techniques such as devil’s advocacy, since these guide the process in ways that minimise bias.
In August there was a surge in mergers and acquisitions activity (e.g. BHP Billiton’s bid for Potash, Intel’s for McAfee). Thompsons Reuters’ data show nearly $90 billion worth of deals in one week alone, making it the largest weekly total for 4 years. This activity flies in the face of evidence showing a surprising lack of success e.g. simply announcing merger bids wiped off over $220 billion from the share price of acquiring companies over the period 1980 – 2001 (Moeller, Schlingemann, and Stulz, 2005); at best there is only a 50/50 chance of success (McGee, Thomas and Wilson, 2005). In any other context these chances would be considered far too risky. So why do CEOs and organisations do it?
Evidence suggests that key decision makers are blinded by overconfidence, leading them to over-estimate their own chances of success. They know that many other organisations have failed but are confident about their own chances of making it work. However, research shows that they are, in fact, overconfident and just as likely to fail as other organisations. This overconfidence is due to the short-cuts in thinking (heuristics) decision makers use when faced with complex decisions. These short cuts are very useful because they make complicated problems simpler and easier to resolve. However, when simplifying in this way crucial information is neglected and this usually reduces the accuracy or appropriateness of the solution.
One important simplification strategy used by decision makers is confirmation thinking - a strong tendency to focus on information that supports an existing belief and ignore information that challenges it. This leads to a number of biases:
• Overconfidence – people hold beliefs with higher degree of confidence than they should because they fail to take account of the information challenging this belief. Research shows that CEO overconfidence is a major factor determining mergers and acquisitions – those initiating these activities are much more confident of success as compared with external experts and analysts and this level of confidence is much higher than the actual likelihood of success.
• Optimism – allied to overconfidence; decision makers have a general tendency to believe that, in comparisons to people similar to themselves, good things are more likely to occur to them and that bad things are less likely to occur.
These factors mean that CEO judgements of success of mergers and acquisitions are overly optimistic and downside risks overlooked so not addressed.
Can anything be done to rectify this situation and help CEOs and organisations make less biased decisions? Research shows that there are three ways of overcoming this problem:
• Better governance: evidence shows there is more merger and acquisition activity when CEOs also act as president and chairman of the board (Malmendier & Tate, 2008); this highlights the crucial role of weak oversight by boards of directors and the need for better governance.
• Train key decision makers to think smarter: people can be taught to think in ways that reduce overconfidence.
• Better decision making processes e.g. use of techniques such as devil’s advocacy, since these guide the process in ways that minimise bias.
Professor A John Maule
Director: Centre for Decision Research, Leeds University Business School
Linstock Communications Associate
www.linstockcommunications.com
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