Uncertainty – Strategy’s Final Frontier

For strategists, medstore uncertainty is the final frontier.

We can never know what the future will bring, capsule so uncertainty permeates all strategic decisions – assumptions must be made.  But the models that are used for strategy development often obscure the foundational role assumptions play.  Their accuracy is presumed and attention focused on constructing elegant analytical edifices rather than solidifying the base upon which they are built.  Confidence in the results increases at a faster rate than does their accuracy.

Behavioral factors are at play here.  Psychologically we are highly averse to uncertainty – it discomforts us hugely.  We prize feeling that we have, if not control, at least a firm grasp on the world around us.  Sub-consciously we are seeking confidence – confirmation that we can take action – as much, if not more than we are seeking accuracy.  Our psyche conspires in the delusion.  Better decision-making (the manifestation of accuracy) requires us to suffer the anxieties that fully recognizing the existence of uncertainty provokes.

Fallacious confidence leads to resource misallocation, most damagingly with big investment decisions such as acquisitions.  Stretching back to the 1970s, studies have shown that most corporate acquisitions destroy value for the acquiring company – the most recent suggesting in between 70% and 90% of cases.

Analysis equates to the search for truth.  It is most powerful when built upon facts – something either happened or it didn’t – which is only possible when looking backwards.  Not surprisingly, high quality analysis has proved critical to the productivity gains which have driven profits growth in most large companies over the past quarter of a century.

But when we seek to apply judgment to that fact – why it happened, what it means in a broader context – more than one interpretation appears possible.  The corridor of possible truths starts to widen.  Attempting to understand the relationship between many facts – correlations or causal links – widens it still further.  When we model the future from analysis of past events, the range of possible truths becomes more a canyon than a corridor.

As behavioral economists have highlighted, uncertainty provides fertile ground for bias to flourish, particularly the double-bind of over-optimism compounded by over-confidence.  Finding truth in the future is beset by the mass of possibilities; and our tendency to be over-optimistic stems, at least in part, from probability blindness.  The significant advances in capabilities for analyzing historic data have not been matched by advances in (or broadening of) our understanding of probability.  One result is the conjunction effect – a failure to adjust for the compounded probability of multiple events.

The probability of three reasonable assumptions all coming true would itself appear to be reasonable.  But that is not the case.  Take as an example an acquisition valuation where there are three key variables – the growth rate of the market the target company operates in, the target company’s share of that market and its profitability.  Each assumption has a 75% probability of success (the assumed rate or better is achieved) – superficially very reasonable.  But the probability of all three being met is 0.75 x 0.75 x 0.75 or 42%, somewhere between possible and unlikely.  Change the probability to 70% and the compounded likelihood is just 34%.

Research can help improve assumption accuracy, but lack of time – particularly where acquisitions are concerned – works against the careful accumulation of the fact base necessary for validation.  Insight quality increases as fact bases mature, the passage of time allowing data to emerge and harden, hypotheses to be formulated and tested, alternatives to be generated and further experiments to be conducted.

Externally-driven timetables typically don’t allow the luxury of extra time.  But that should not excuse accepting lower quality assumptions when significant corporate funds are being risked.  A more proactive approach to uncertainty management is required, most importantly starting the process earlier – in advance of when decisions need to be made.

Fortunately there are a number of established tools and techniques that, when used in an integrated way, can enable better uncertainty management.  They include scenario and contingency planning, likelihood and impact analysis, a discovery-driven approach to resource allocation (or the crawl, walk, run approach), Monte Carlo simulations and the use of decision markets.

Only the last is a relatively new technique, the others having been around for many years.  But if used at all, these tools tend to be employed in isolation.  Using them in an integrated way will systematically improve assumption quality and strengthen the foundations of strategy formulation.

Elusive Growth: Why prevailing practices in strategy, marketing and management education are the problem, not the solution, by Jack Springman, will be published in Summer 2011

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About Jack Springman

I am a consultant with experience in business strategy and customer strategy development, customer management and customer service transformation.