Thursday, February 01, 2007

machiavellian nature of the real decision maker

My last two blog entries have described the theory of economics being an abstract method of measuring both society and the environment. Investment time horizons should be extended to reflect the long term nature of an investment's impact and that when this is done, economic evaluations can be used as the sole tool for decision making.

Unfortunately, this is a normative theory; it describes how I think things should be done. As a consultant, it is my role to spend too much of my time contemplating how to make things more effective. This is the way we compete with other consulting organisations. While the rest of the world gets on with the doing, we contemplate how the doing can be more effective.

The other thing we do is contemplate how we can incorporate this normative theory into the real world. In essence we contemplate how we make it a positive theory.

To do this, we have to develop positive theories of our own for current practice. Positive theories are theories that describe the way things are actually done rather than those that describe how they should be done. This blog entry aims to describe how investment decisions are currently executed. It is based on observations over 14 years across dozens of industries in 10 countries.

The common thread between my normative argument and the positive theory is the importance of time horizons. In our positive theory, people are motivated by improving their own lot. Altruism does not exist. In this light, a decision maker makes decisions that suit his or her motivation to improve their own position. Sometimes, this will be an improvement to their financial position. In this instance people will make the decision that will increase the chance of financial reward. In other instances it will be power, a lasting legacy etc.

The time horizon of the decision maker looking to increase their own financial wealth will be extremely short. Even a non-fraudulent decision maker with these motivations will focus on projects that "payback" quickly instead of long lead time projects that "payback" 10 times the amount in present day terms.

If the decision maker wants to leave a legacy behind, then they will focus on longer term decisions. Their tenure in the organisation will be longer and their succession planning will be detailed and targeted. It is important for the information providers to understand the motivations of the individual making the decision. These motivations will drive the tools being employed by that organisation to assist them to make a decision.

Here's some observations to assist in determining what drives your decision makers:
Financially motivated
  • Payback used as assessment method
  • Subjective overlay applied to financial analysis (e.g. 2+2 = whatever you want it to be)
  • Focus is on short term (e.g. quarterly) results
  • Reward structure is financially based.
  • Analysis is retrofitted to a decision
Legacy motivated
  • Cost/benefit analysis is used over the life of the investment
  • Focus is on long term vision of the organisation
  • Vision has meaning to everyone in the organisation
  • Rewards are a mix of financial and non-financial
  • Financial analysis has forecast error only not bias error
  • An analysis is never retrofitted to a decision
Of course, even positive theories are falsely formulated. I'd be very surprised if this theory wasn't shot down in a ball of flames. Please feel free to do so. Let the evolution begin.

investment time horizons

This blog entry will put forward a case for a radical redesign of investment time horizons.

What are investment time horizons? Investment time horizons are time periods applied to the assessment of the potential of an investment in terms of its economic impact. As per my previous blog entry, economic impacts are results or consequences of social and environmental change caused by an investment. Some examples; many people in society now walk around with headphones or ear pieces on, listening to music emanating from a device that has been called an iPod or MP3 player - if we are not being brand specific. The original investment by apple in product development, production and marketing of the iPod has had significant economic consequences for a subset of society that this investment has impacted on. This can be measured by the net overall increase in market value attributable to the companies that are impacted. I say net, because some companies, like Sony, have lost market value even though they have brought out their own MP3 devices. Suppliers of component parts, and retailers like Harvey Norman have gained market value as consumers decide to spend their hard earned money in these retail outlets rather than on clothes, drink or food. Clothing and food outlets have lost for the same reason. However, the net result is probably positive as the device has created a feel good effect that makes people spend money.

If there is a net increase in wealth from the release of the iPod, which I suspect there is, then the increase is societies way of rewarding the innovation. The increase represents societies view of the higher standard of living the device has given them.

Another example is the increase in property values delivered to houses or land that surrounds new infrastructure development. This increase in value is reflecting the greater standard of living provided to those impacted by the investment through faster travel times, better health, safer living etc. This example illustrates the full process of investment decision making. A government makes a decision to build public transport in an area, the affected area now has faster commuter times; be they by car, rail or bus. Housing prices increase due to this higher living standard. More people are attracted to the area because of the higher living standard. The wealth increase is the result of the social change.

However, all of these examples are transient. The iPod will be superseded by some other piece of technology in the future. Alternatively, people may start to suffer hearing loss from playing them too loud or cancer from magnetic radiation. When these events occur, the economic value will erode, and if Apple hasn't innovated with something new, it's market value will deteriorate.

With this in mind, to what time horizon should we be looking to when assessing the potential benefits of the investment? Obviously, this will vary depending on the investment, but typically, the time horizon used in practice is too short. In the iPod example, did Apple assess the risk of being sued for causing deafness or cancer? If this effect is large enough, it could threaten the very existence of the organisation (e.g. tobacco companies and their short term assessment on the effects of lung cancer on their businesses and asbestos companies and their short term assessment of the effect of asbestos on their companies). Eventually, the social consequences will impact the business.

The question is, should these long term consequences be included in the assessment when making the decision to invest? It should be noted here that I am not asserting that iPods will make people deaf or will cause cancer. What I am asserting is that these possibilities should have been reviewed when making the decision to launch the product. If the risks were high, then mitigating steps should be taken immediately, and the overall economic value of the product reduced accordingly.

In the public infrastructure example, over time, the roads will become blocked again, pollution will increase and the value society places on the area impacted will reduce. Should this be taken into consideration when making the decision to invest?

My belief and answer to these questions are yes. Time lines must be lengthened. Even though forecasting the effects will be difficult and the variance of our estimates high, we must start modelling these consequences if we are to make better investment decisions. The long term will always, one day, be the short term. Asbestos companies are now paying for what they once thought was a long term problem. It is now their current problem. If they were to include the negative consequences back when they made the decision, would the decision have been the same?

Sometimes we will not know or be aware of these consequences, but investment decisions are not a buy and hold proposition. Decision makers have the capacity to change their mind at any moment. By constantly re-evaluating the investment decision and by keeping the time horizon long, we should be able to adjust quicker to negative consequences and hence reduce the negativity.

It is my belief that in using this longer term model, economics becomes the sole measure for assessing an investment decision, but the drivers for that assessment, social and environmental change, are being properly incorporated into that assessment.