Psychologists have studied the behavior of people in corporate business for several decades. These professionals believe the biases and misconceptions leading business people exhibit influence workplace decisions. Some biases and misconceptions are excessive optimism, overconfidence, confirmation bias, and projection. As business managers frequently make corporate decisions in the face of risky alternatives, the psychological need to avoid financial losses is stronger than long-term financial gains, reliable products, and public safety.
Biases
A variety of behaviors in the business world compel people to make poor financial judgments, irrational decisions, and uninformed economic forecasts. One reason for these circumstances is people often display biases, which are cognitive predispositions that lead to mistakes. Most people, in general, try to think positively, perhaps because all languages have many more optimistic adjectives than pessimistic ones. However, according to James Montier, the inclination to look at the brighter side of things often leads to excessive optimism, which is a recurring bias in the corporate world. Business managers demonstrate this type of bias when they become unrealistically hopeful about their business activities.
On July 26, 2004, BusinessWeek published a cover story about the business behaviors of Chief Executive Officer Scott McNealy of the technologically advanced firm Sun Microsystems. According to the article, in 1995 McNealy made an unpopular decision when he opted not to follow the market trend of making servers for Microsoft Windows software. Instead, McNealy instructed Sun’s technicians to create the company’s personal computer software called Solaris. Although Sun’s competitors IBM, Digital Equipment Corp., and Hewlett-Packard thought it would be profitable to develop “new servers to run the next version of Microsoft Corp.'s Windows software,” Sun’s servers outperformed the competition in reliability, security, and speed. As Sun’s software rose in demand and profits increased tremendously during the technology boom of the latter 1990s, people looked at McNealy as the prototype CEO.
Bad Economy
When a recession began in March 2001, business leaders from Wall Street advised Sun that the recession would be extensive and lengthy. As indicated in the BusinessWeek article, Wall Street officials suggested to McNealy that he cut down on expenses, lay-off non-essential workers, reduce research projects, and create inexpensive products. However, McNealy ignored the advice because he believed the recession would be short, approximately two months, followed by a sharp economic upturn. With his unsubstantiated ideas, McNealy increased expenses by creating new projects. The recession lasted much longer than McNealy forecasted (nine months), so his overly optimistic view of the economy ultimately caused Sun's sales to drop 48% from 2001 to 2004, and its stock dropped from $64 to approximately $4 per share during the same period.
In the estimation of Hersh Shefrin, McNealy’s “excessive optimism” caused the CEO to make decisions that were detrimental to the financial success of Sun Microsystems. Shefrin indicates that the National Bureau of Economic Research (NBER) officially determines the start and end of economic recessions in the United States. According to NBER, from 1944 to 2000 all economic recessions have lasted an average of 11.6 months, and during every recession “gross domestic investment (GDP) fell for 12 months.”
Overconfidence
American economic history indicates that recessions are never brief or “sharp-edged,” as McNealy thought. Therefore, he not only had an overly optimistic view of the economy, but also he displayed another bias - overconfidence. This bias occurs when people misunderstand or overestimate their abilities. In other words, people who exhibit overconfidence distort reality because they think they are smarter than they are. In McNealy’s case, he thought he was smarter than the Wall Street analysts and Sun’s economic advisors who agreed with Wall Street that the recession would not be brief.
Confirmation Bias
Psychologists indicate that cognitive dissonance precedes confirmation bias. Cognitive dissonance is the mental conflict a person experiences when the person receives information or proof that his or her beliefs or ideas are incorrect. According to Montier, a big part of this mental discord is the denial of new information. To challenge the new evidence as a way to resolve the mental conflict, a person will either seek information that agrees with his or her beliefs or ignore the new ideas, which is “confirmation bias.”
McNealy exhibited this behavior after Sun’s top executives informed him that the recession caused the leading company in the industry, Cisco Systems, to cut costs because Cisco’s revenue had declined drastically. The executives advised McNealy to implement similar measures. Although Sun’s executives presented solid evidence about the suggested length and inevitable effect of the recession, it did not agree with McNealy’s belief that the recession would be brief. Consequently, the CEO rejected all suggestions to cut costs, and his decisions led to the firm’s drastic decline in revenue.
Projection
When a person attributes his or her faults to others, psychologists refer to this behavior as projection. In other words, one does not acknowledge his or her faults; instead, the person attaches those faults to other people. This behavior happens quite often, especially in American international business. As businessmen such as Dick Cheney, Donald Rumsfeld, and George W. Bush moved into the political arena, they used politics and national security to enhance their business interests. To hide their true intentions, these businessmen/politicians ascribed their faults, including dishonesty and voracity, to international politicians.
Dick Cheney was CEO of the Halliburton Corporation in 1995. When he became vice-president of the Bush administration in 2001, he had a great deal of stock in that oil company, which had over 70 offices around the world, including offices in Iraq. In The Shock Doctrine, Naomi Klein illuminates the relationship between the rapid rise of Halliburton’s stock after 2003 and the American invasion of Iraq. She suggests that businessmen/politicians like Cheney “conflate corporate interests with national interests…” by dictating to the American public the countries that are anti-American.
Mass Projection
Klein explains that executives and major stockholders of American businesses such as Halliburton and Lockheed respond inappropriately to reasonable business requests by foreign countries. When a country such as Iraq, for example, requests that American businesses pay taxes, observe environmental policies, and pay employees a fair wage, the American businessmen/politicians interpret these requirements as anti-American ideas. Because American businesses exploit the land and the workforce of foreign countries, a demand for fair treatment is certainly not an “anti-American” act.
The businessmen, however, use politics to label foreign countries negatively when they want American companies to follow appropriate business guidelines. In other words, as in the case of Iraq, American business managers were “anti-Iraq” although the Bush-Cheney administration and other business managers depicted Iraq as “anti-American.” Because such incidences have become part of America’s international business culture, Klein refers to this behavior as “mass projection.”
Framing Effects
Business theorists use the word “frame” to mean a description of a job decision. Therefore, a “framing effect” is a determination that is influenced by the person’s decision-making method in a particular situation. Job decision-making or “framing” is an essential characteristic of prospect theory, which Shefrin explains as “a general psychological approach that describes the way people make choices among risky alternatives.” Prospect theory has two fundamental attributes: “loss aversion” and “aversion to a sure loss.”
According to Shefrin, several psychologists studied people’s responses involving the possibility of financial gains and losses. If a person, for instance, rejects the risk of winning or losing money, say $50, when the chances of either are 50-50, it means the person places more weight on losing than on winning. However, most people accepted the 50-50 risk when the possible lowest winnings were $125 against possibly losing $50. Therefore, although the chances of winning and losing were the same, people believed that the possibility of winning a larger sum of money than they could possibly lose was worth the risk. Psychologists indicate that this phenomenon is loss aversion because “…people experience the loss of $50 two and a half times ( = 125/50) as acutely as a $50 gain.”
Pharmaceutical Company
Shefrin explains that top-level managers at the pharmaceutical firm Merck & Co. were loss averse when they improperly weighed the company’s “intangible assets” (researchers and scientists) against certain financial gains in the future. Between 1983 and 2003, Merck kept its debt under 20 percent of its total assets, which is relatively low. Most corporate finance texts suggest that debt is advantageous to corporations because they can use it to “shield investors from corporate taxes,” which would lower the company’s tax bill. Merck’s managers, however, viewed increased debt as financial instability that would cause scientists and researchers to leave the firm. Although increased debt would have resulted in financial benefits, the managers decided to maintain their traditional debt policy because, psychologically, avoiding a loss was more important than a subsequent financial gain.
Merck & Co. became one of America’s prominent pharmaceutical companies during the 1990s. Merck sold the popular drugs Vasotec for high blood pressure, Mevacor for cholesterol, Prinivil for cardiac medicine, and Pepcid and Prilosec for ulcers. These drugs earned the company more than $4 billion in 1999 alone. By 2001, however, the popular drugs, which had been in existence for approximately 15 years (patent protection limit is 17), would lose their patent, so Merck had to create other money-making drugs.
In the spring of 1999, the Food and Drug Administration (FDA) approved Merck’s painkiller drug Vioxx. As part of the approval process, the FDA instructed Merck to study the drug’s side effects, because, as Shefrin explains, researchers had discovered that people who used similar drugs like aspirin and Aleve developed stomach ailments. After Merck conducted its study called Vioxx Gastrointestinal Outcomes Research (VIGOR), investigators discovered that Vioxx did not cause stomach irritation, but it could cause strokes and heart attacks.
Aversion To A Sure Loss
Merck executives, including Chief Executive Officer Ray Gilmartin and Chief Financial Officer Judy Lewent, knew about the harmful side effects of Vioxx. According to business protocol, however, the executives faced an economic problem, not a moral dilemma. The executives considered the tremendous profits the company would attain by selling Vioxx without disclosing the side effects. The risk would be great because withholding such critical information often results in lawsuits. On the other hand, the executives understood they could sell the drug in a small market as a painkiller to people who did not have heart problems or high blood pressure, but the company would take a sure financial loss. What would Merck do?
As indicated by Shefrin, the risk of a possible financial gain, even when the percentages are unfavorable, outweighs a definite financial loss, which is “aversion to a sure loss.” Merck executives decided to take the risky option. They chose to sell Vioxx without informing customers of its dangerous side effects. To support their risky decision, Merck executives refuted a 2004 FDA conclusion about the danger of Vioxx. The company also challenged researchers from Harvard University who suggested that Vioxx was not safe to use.
According to Shefrin, more than 27 million people used Vioxx from 2001 to 2004. After the public became aware of the danger of Vioxx, Merck took it off the market in 2004, but the lawsuits already had started. In 2005 a Texas jury awarded $253 million to a victim of Vioxx, and 4,200 unhappy customers had filed lawsuits. Although Merck has a solid business foundation today, in 2005 the company’s “market capitalization fell by 7.7 percent…” CEO Raymond Gilmartin retired that year and Richard Clark became the President and CEO of the company.
Sources:
- Kerstetter, Jim and Burrows, Peter, “Sun: A CEO's Last Stand.” BusinessWeek. July 26, 2004.
- Klein, Naomi, The Shock Doctrine. New York; Henry Holt and Company, 2007, pp. 391-393.
- Montier, James, Behavioural Finance. Chichester, West Sussex; John Wiley & Sons, LTD, 2002, pp. 2-4.
- Shefrin, Hersh, Behavioral Corporate Finance. Boston; McGraw-Hill Irwin, 2007, pp. 3-15.
William Cook - Mr. Cook is a graduate of Hunter College of the City University of New York. He is pursuing a Ph.D in History and Education.
