Governance and human shortcomings
The Swedish Riksbank's prize in economic science to Alfred Nobel's memory this year went back to an economist whose research is about human shortcomings. He receives the economics award for having "incorporated psychologically realistic assumptions into analyzes of financial decision-making". In the justification, the Royal Academy of Sciences writes that Thaler "explored the consequences of limited rationality, social preferences and lack of self-control" and how these factors affect both personal financial decisions and markets.
We are obviously not as rational as the theories we learn in school want to apply. For example, we value our own things and areas higher than others, and in various ways seek to legitimize our decisions, regardless of whether the information for the decision is irrelevant or if patterns are incorrect. We are affected by our brains that all too often act impulsively, myopically (near-sightedly) and manipulatively.
Our preferences are inconsistent and we are more impatient in the short term than in the long run. For example, we prefer a decision that means that we may retain 90 percent before a decision where we lose 10 percent even though the two alternatives are identical. We also prefer SEK 100 today over 110 next week, while we prefer SEK 110 in 52 weeks before SEK 100 in 52 weeks.
I wonder if paying attention to Thaler's research will help to develop how we govern and lead our companies and organizations based on the now recognized science of our human behavior. Prize winner Richard M Thaler thinks that it is possible to push (nudge) or influence our behaviors to become more effective and rational in our decision making by developing the way of thinking and the processes that support our plans and actions.
Let us take a closer look at the most prominent financial instrument - the traditional budget process. A process that, in its very design, reinforces our tendency to short-term and encourages manipulative behavior. As an example, a manager who has a cost budget will always want to spend all resources allocated as the probability then increases to receive the same allocation or higher next year. Similarly, anyone with a sales budget will always want to negotiate the budget (target) to make it easier to reach. If sales and possible bonus ceilings are achieved, they will try to move sales to the next year to get a good start to the year. Furthermore, those who reach their budget (forecast) show that they are good at forecasting and good at leading, which increases the likelihood of success in future negotiations.
The December effect that arises in many organizations is just one example that, in the longer term, leads to poorer performance of employees and reduced returns to owners and financiers. The budget game may thus seem rational, but it certainly does not have a full foundation in reality. A manager who bases his budget on facts and realistic assumptions risks reducing appropriations, reducing his responsibilities and power.
Governance is about influencing behaviors and in order to do so, the traditional governance models based on assumptions of rationality are required. If the models are challenged and developed, the hope is that our plans and decisions can lead to actions that are more rooted in today's complex reality. We already see today that the organizations that develop their planning and decision-making processes in harmony with both business rhythm and human behavior achieve better results. So far, these organizations are in the minority, but perhaps the recognition of Richard M Thaler's research is just what is needed to push the majority in the right direction.
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