The Science of Business Decision-Making
Owning a business requires constant decision-making. The decision to start is a big one. Immediately after that, business owners must constantly decide issues big and small. After each decision, they must wait to see the result of the decision, while hoping that it turns out as planned. This can be a roller-coaster at best and a soul-drowning sea of anxiety at worst. Gamblers share one thing with entrepreneurs. They make monetary decisions that have payouts or losses and a similar experience of waiting for the outcome. Though their stakes are not nearly as large ours.
Entrepreneurs use their business acumen, years of experience, and that all-too-familiar “I just know it’s right” sensation. Gut feel is a fine thing, and could even be the best way to start the decision making process because it begins action. Wise gamblers and casinos use gut feeling too, but rely mostly on probability theory grounded in science. Entrepreneurs who add probability theory to their arsenal fare much better than those who just use horse sense. This article is about how to use the same probabilistic decision making for non-statisticians.
I have talked a lot about decision-making on Jim Blasingame’s radio show, the Small Business Advocate. In my book, The Successful Entrepreneur: American dream done right (Glenbridge Publishing – available hard-copy and Kindle from amazon.com) I give a detailed roadmap for business decision making from start-up to maturity, but here are five tips for making good business decisions by thinking the way gamblers and casinos do.
Tip #1: Seek negative evidence. It’s a human tendency to ignore negative evidence, no matter if the issue is love or money. Often we get an idea in our heads and plow forward, full force and minimize or ignore anything that seems as though it might stop us from reaching our goal.
Max Bazerman in Judgement in Managerial Decision Making (Josey Bass) uses this example: You have two consulting firms – Yesman and Devil’sadvocate. Yesman will agree with everything you say and, at great expense, give you a long, detailed report on why any idea you have is a winner. Devil’sadvocate will not be nearly as kind. It will meet any idea have with 10 reasons it won’t work. Bazerman asks, “Which is the more valuable consultant?”
Of course people answer Devil’sadvocate. But the firm toward which we are emotionally impelled is the love-for-sale Yesman. We want to hear our ideas categorized as winners, but reality demands we consider what Devil’sadvocate has to say. Can we really do this without paying anyone? Yes, and it’s easy.
First, become your own devil’s advocate, or have a trusted friend help you. Anytime you want to make a major decision, think of as many reasons why it’s a bad idea as you can. If you haven’t scared yourself off, move to the next step, because chances are it’s a pretty-good to very-good idea.
Second, is a technique I’ve used many, many times and it’s an eye-opener. Before starting a business, write a brief description of your proposed business. Then write similar descriptions for four fictional competing businesses. Write these as seriously and enthusiastically as you write the one for your proposed business. Then ask people who know this field of business about which they think is the best. This also works for new products or services of established businesses.
Most people unknowingly search out Yesman by saying something like, “I’m thinking about opening a business (launching a new product) that involves exporting maple syrup, what do you think?” If you ask the question this way, you’ll usually get a positive response. Instead, have your maple syrup export idea paired with four others. You may get a different response because you’ve, in effect, given people permission to tell you what you don’t want to hear.
I found that in short order, people can cull winning ideas from the “maybes” pretty quickly at little or no cost.
The best news is that if your idea is a winner, you’ll also know very quickly and with confidence. If you can make it through steps one and two, it’s time to take your idea the next level of seriousness and planning.
Third, take your idea to the SBDC or to Score whether it’s start-up, expansion, financing, marketing or HR. They have experienced consultants who will look at your idea for free and advise you based on years of business experience. Ask them to be your devil’s advocate. They will, and if they don’t scare you away, you’ve probably got a winner!
Tip # 2. Use a large sample size. Casinos know that if you gamble for an hour you could make money. But if you gamble for 12 hours, you most likely will lose, and they go to great lengths to keep you there -- usually by making the experience as social, engaging, or exhilarating as they can.
For business people the scenario goes like this: a new product or service comes out and sales are either amazing or disappointing. Do you make plans on support, sales, and inventory based on that level of sales continuing or do you take a wait-and-see approach?
Take the wait-and-see approach. In each case, the sample size is too small to extrapolate future sales yet. This is true for the gloom of a tough first month or the exhilaration of a super start. Sales could be abnormally high because leading edge consumers love to buy new products, and abnormally low because of awareness, pricing or consumers are waiting to see if the market responds favorably.
The smaller the sample size the more variability you can expect. So, if you are trying to glean how much revenue a product or a new business will bring in based on a month or quarter’s worth of data, be careful. Wait for longer – six months to a year, if you can, before making revenue projections a year or two out.
Tip #3) Beware of escalation of commitment. In The Successful Entrepreneur I pose the question – if you put a frog in a pot of boiling water, will you kill it? The answer is, no. It will jump out. (Believe me and don’t do this to a frog!) However, if you put a frog in a pot of cold water and turn up the heat will it die? Yes, because a frog is cold-blooded and will adapt its body temperature to its environment – and there will come a point in which the water is so hot it can’t move its muscles and get boiled do death. (Again, no frog experiments!)
It’s very easy to become the frog in cold water. If I said to you, would you risk losing your house, your savings, and run up astronomical amounts of debt and then take it to a casino’s roulette table, would you do it? Of course not because that is a really dumb idea. Same with taking that amount of risk in your business.
No one loses a thousand dollars on one bet. They lose a hundred, and then red comes up five times in a row and they bet a hundred on black. Bam – down $200, then three and four hundred dollars. Then they figure the house’s luck will fade, so they wait for their turn for lady luck to shine on them for a while. Hours pass, and when their losses hit four figures, figure it’s time to quit and have a $1,000 free drink.
Small businesses experience many of the same decisions, but instead of the drama’s being condensed to a night, it can get stretched out to a year or two or three or more. It’s very human to want to make things work. If you’ve spent two years and have invested $30,000 in a new product, you want things to turn around to recoup your investment of time and treasure. But if you feel like you’re the frog in cold water cut your losses and move on – which is one of the toughest things to do. The alternative is losing $60,000 and three years work or $100,000 and four years work. Take that same money and invest it somewhere where you have a better chance of succeeding.
This is where a third party, dispassionate decision is best. Really listen and be willing to walk away if you’re destined to lose more.
Tip #4 The law of averages is real. Baseball fans know that also-ran players can have hall-of-fame statistics a month into any season. After 100 at-bats, they can hit far better than Ted Williams could have dreamed. But by mid-season, they’re likely back to their old selves hitting about .270, which is credible, but certainly not superstar material. Likewise, the superstar who couldn’t bat his weight in May by September will be among the league leaders again.
Entrepreneurs can use the law of averages (known by statisticians as regression to the mean) in an important way, especially at start-up. Here’s how. Find five businesses similar to yours or the one you’re thinking of starting. Most business people are willing to help others, and in return you can provide counsel to them at some point. After explaining the details of your business, ask them this: “In very general terms, what could I expect for revenues and costs for the next one, two and three years.
If you ask them for their financials, there simply isn’t any way you’ll get anywhere. But by asking them such a non-detailed question, you’ll get some very good information that’s surprisingly accurate. Using a spreadsheet (or the free Excel template on The Successful Entrepreneur’s website, listed below) average the five responses you get, and you’ll have a very accurate window into the future. Why? The law of averages. Here’s the link.
http://tomanastasi.com/related_links.asp
When entrepreneurs I was consulting for used this technique and gave me permission to use their data for The Successful Entrepreneur, here’s what we found. We surveyed Ice Cream stands and copy shops in the New Hampshire/Massachusetts area.
Ice Cream Stand Copy Shop
First Year Years 2-3 First Year Years 2-3
Revenue $70,000 $75,000 $100,000 $200,000
Expenses $90,000 $40,000 $90,000 $120,000
Net Profit(Loss)-$15,000 $30,000 $10,000 $80,000
(Before taxes)
The couple who wanted to start the ice cream stand held off, but the woman who wanted to start the copy shop when on, but made sure to have enough money saved to get through that first year. When my SBDC clients used this technique and reported back to me, we consistently found accurate data three years out. Of course, there are no guarantees – you still have to use your business sense.
Tip #4) Be careful of “sure things”. The surveying technique above works very well for seeing what the future offers 12-36 months out, but doesn’t work nearly as well for predicting how a single decision will pan out. For that, we need to look at probabilities. Statisticians look at any event and assign a probability between 0% (couldn’t possibly happen) to 100% (it’s certain to happen.)
In the physical sciences it’s easy – if you drop your pen, there’s a probability of 100% it will fall and a probability of 0% it will float in the air. In gambling, it’s also pretty straightforward – if you flip a coin, there’s a probability of 50% of getting either a head or a tail. Casinos make lots of money because they make sure they odds are in their favor – but even still, there are days when casinos lose money, but not many.
Rolling the dice, at the craps table, or figuratively with a business decision, is tricky because no matter if it’s a new product, an ad campaign, or a new hire, you use your best judgment, but in many ways the feeling is very similar to watching the little ball go around the roulette wheel, waiting to drop.
A major rule for decision makers: Never assume that any decision “has to work,” “is going to work,” or is “a can’t miss” – no business decision has a 100% chance of being successful.
For instance, an amusement park in New Hampshire knew it would be hard to get through the winter, so they did a big bet-the-company marketing event at the end of October in 2011 to have enough money squirreled away to pay winter bills.
They turned their park into a Halloween haven – with state-of-the-art haunted houses, and a fully supported marketing blitz. There was quality, buzz, and from all appearances it was a good decision that would get them through the winter. Hurricane season was over, and even if it rained, there were enough in-door activities to interest customers.
They listed their probability of success at 95%, and the probability they would at least break even at 100%. It all made sense; it couldn’t lose.
Disaster hit. On October 29th one of the biggest blizzards in decades hit New England. There were three feet of snow; and power was lost for over a week and there were driving bans in most cities. Snow in that amounts simply “doesn’t happen” in October in New Hampshire – it never had, and probably won’t again for decades.
The probability of a blizzard in New Hampshire in October was thought to be 0%. But it was never 0%. It was among a wide variety of low probability events that could also have occurred. We think that things that are unlikely won’t happen because the alterative would be rumination to the point of paralysis.
Driving is by far the most dangerous activity most of us do, but if we actually considered the perils of getting behind the wheel, we’d be homebound permanently. So to make it through the day we convince ourselves that events that are unlikely won’t happen (falsely assigning a probability of 0%) those that are very likely to occur have a probability of 100% (falsely assigning a probability of 100%).
That’s a huge trap for business owners, which is why business owners face such a conundrum. If we wait until there is certainty, we’ll decide nothing The best we can do is never assume that anything is impossible or certain and plan for that reality.
One more thing to consider. If we’re 95% certain a weekly ad will break even or pull more than its cost, that means that there’s 1 in 20 chance is won’t breakeven and two to three times a year will lose money. Does that mean don’t advertise? Absolutely not. Just plan for that and you’ll be okay.
Tip #5) Manage risk. In situations of gain we tend to be risk averse and in situations of loss we tend to be risk seeking. The technical name for this is prospect theory, developed by Amos Tversky and Daniel Kahnemam. Here’s how it works. Imagine you went to a horse track with $50 in your pocket and it’s the last race of the day. Assume you lost all but $5.00. Many people in that circumstance would bet on a long shot so they could break even or come home a winner – we would be risk seeking. However, if on the last race, you were lucky enough to be up $100, you might want to stay a winner and would make small and conservative bets to avoid losing winnings – we would be risk averse.
Entrepreneurs behave in the same way. If a business owner is behind in his or her sales forecast, he is much more likely to make risky decisions to turn things around quickly. The sad reality is that long shots win infrequently at the track or in the business world; therefore, that risky long-shot decision most often makes a tough situation worse. Of course if business is good, there is also danger in getting too conservative by eschewing growth opportunities by being too conservative.
The secret is no matter if things are going well or if you’re struggling, make measured decisions that balance risk and reward. Don’t go “all in” and try to turn things instantly. Likewise don’t be so conservative that you overlook sound revenue opportunities.
Final thoughts
Owning a business is tough; every decision you make is a roll of the dice. Fortunately, your business experience will help you, and most of the decisions you make will be positive, or at least neutral. Most of us were employees before having our own venture, and it’s always easier to spend someone else’s cash. The same decision making process should occur even if we’re using our own money.
If we think dispassionately and make decisions the way successful gamblers and casinos do using probability science, then we’ll make many more positive decisions and fewer of the decisions we regret.
There are a lot of free spreadsheets and templates you can find on tomanstasi.com
Tom Anastasi has worked with small businesses for over 25 years and the title of his fourth book is The Successful Entrepreneur: American Dream Done Right. Copyright 2013, author retains ownership. All Rights Reserved.
