Research Highlights
The Human Element in Investment Decisions
—
Better understanding the psychological processes underlying the way managers make decisions can help explain strategy choices.
When managers make strategic investment decisions, they tend to anchor their decisions on the average return on investment, or average ROI, that can be expected post-investment, rather than on the anticipated marginal profit measured by the discounted cash flow, or net present value (NPV) – thereby deviating from a firm’s overall goal of maximizing profit. This decision-making behavior, subtle but critical, was recently demonstrated by NYU Stern Management Professor Zur Shapira.
Professor Shapira, along with Carlson School of Management Professor J. Myles Shaver, devised studies that teased out this counter-productive pattern and described it in “Confounding Changes in Averages With Marginal Effects: How Anchoring Can Destroy Economic Value In Strategic Investment Assessments.”
The authors make clear that a consideration of average return data has its place in facilitating the comparison of investment choices. Yet when an emphasis on ROI becomes the anchor, or in this case standard, for judging investments, it can lead to “nonoptimal” choices, they write.
The goal of the authors' experiments was to assess if decision makers, who tend to anchor on existing average performance benchmarks (e.g., 6 percent ROI), systematically based their decisions on that benchmark, neglecting to take advantage of profitable investment opportunities that would result in a lower ROI (e.g., 5 percent) but with a positive NPV. For instance, they presented a choice of investments where both increase profits but one results in ROI equal or greater to the current ROI and the other lower. The study participants, MBA and executive MBA students with management experience, reliably chose the former over the latter or over a combination of the two even though the latter had a positive NPV. In another study, says Professor Shapira, “when we presented subjects with data in the form of average profit (i.e., ROI) versus total (or marginal) profits, they were more likely to make an investment that decreased total profits, yet increased average profits.”
Better understanding the psychological processes underlying the way managers make decisions can help explain strategy choices, the authors write, and understanding systematic determinants of strategy choice can also help management decode how their firm’s strategies affect performance.
Professor Shapira, along with Carlson School of Management Professor J. Myles Shaver, devised studies that teased out this counter-productive pattern and described it in “Confounding Changes in Averages With Marginal Effects: How Anchoring Can Destroy Economic Value In Strategic Investment Assessments.”
The authors make clear that a consideration of average return data has its place in facilitating the comparison of investment choices. Yet when an emphasis on ROI becomes the anchor, or in this case standard, for judging investments, it can lead to “nonoptimal” choices, they write.
The goal of the authors' experiments was to assess if decision makers, who tend to anchor on existing average performance benchmarks (e.g., 6 percent ROI), systematically based their decisions on that benchmark, neglecting to take advantage of profitable investment opportunities that would result in a lower ROI (e.g., 5 percent) but with a positive NPV. For instance, they presented a choice of investments where both increase profits but one results in ROI equal or greater to the current ROI and the other lower. The study participants, MBA and executive MBA students with management experience, reliably chose the former over the latter or over a combination of the two even though the latter had a positive NPV. In another study, says Professor Shapira, “when we presented subjects with data in the form of average profit (i.e., ROI) versus total (or marginal) profits, they were more likely to make an investment that decreased total profits, yet increased average profits.”
Better understanding the psychological processes underlying the way managers make decisions can help explain strategy choices, the authors write, and understanding systematic determinants of strategy choice can also help management decode how their firm’s strategies affect performance.