Why Desperate Managers Risk It All
Lots of companies risk it all when they don't need to; here's why.
I recently conducted a poll on LinkedIn in anticipation of this post. And it turned out exactly as predicted. The poll was pretty simple. Given that you have to pick one option, which do you prefer?
A sure loss of $900
A 90% chance to lose $1000
The results?
75% of you chose the second option. These two options have the exact same expected value, but what’s appealing about the second option is the small chance that you lose nothing.
This is a really simplified illustration why many companies and managers risk it all versus cutting their losses and moving on. The main thing going on here is a Nobel Prize winning concept called Prospect Theory (read the original paper here). The relevant part of the theory here is that given the possibility of a loss, most people become risk takers. The opposite is true when it comes to gain; people become less risk averse. That is, they’ll take the sure $900 versus a 90% chance of winning $1000.
This is a really important behavior to be aware of for company managers. It explains why some managers (and companies as a whole) completely disregard sunk costs and continue plowing forward on losing propositions. To put it into a real life example, consider this. A manager of company division has put $50 million into a new factory that’s well behind schedule and has wildly exceeded the budget. At the same time, there’s strong evidence that the factory will end up producing something that’ll be obsolete, as some competitors have already surpassed them.
The manager is left with two choices: stop now and cut your losses or throw in an additional, say, $10 million in the hopes that things can get back on track. What do you tell this manager to do?
As a completely neutral observer, you’re probably screaming at your screen to stop and take the $50 million loss and move onto other things. But $50 million is A LOT of money and the manager might have their career on the line. There’s a tiny chance that things can work out and this manager can still deliver on their promises and hit their goals. Until the decision is made to give up, that tiny bit of hope is very powerful. This is why sunk costs are ignored in too many situations.
It’s also why companies insist on risking it all versus pulling back and reevaluating. Here are a few from this annals of company failures:
Nokia going all in on the Windows Phone operating system as they were losing market share to upstarts.
Sears merging with K-Mart hoping that would make both companies stronger.
Borders outsourcing its online sales to Amazon figuring it was stronger as a brick and mortar retailer
Yahoo! buying a big chunk of Alibaba only to sell it back to Alibaba several years later.
And we all know how well these all turned out.
There are lots more of them out there. Tons of startups fall victim to this because they are even more fragile than much larger companies. Larger companies might be able to absorb a few misguided gambles like this, but small startups might only have one shot.
This tiny psychological quirk is something to keep in mind when making major decisions at your company. The vast majority of people are programmed to take the sure thing when it comes to a gain and take risks when it comes to a loss. Neither of these should be the default choice. Sometimes you should gamble to win more (take a 90% chance to win $1000 v. a sure thing of $900). This might be doubling down on marketing campaign that’s working at the risk of blowing your supply chain and hurting every customer. And sometimes it might make sense to gamble versus taking the sure loss (i.e., ignoring sunk costs).
The point is that you need to understand what people’s tendencies are and account for them. As a team or company leader, look for these types of decisions and make sure you and your teams understand the real reasons why you’re making them knowing that your brain is already fully biased to making certain decisions.
Before you go…
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