The People Factor — Compensating for Human Error
The Mario Belotti Professor of Finance
Businesses are run by people who have their own personality quirks and a capacity for self-delusion. Yet the way this fact affects business decisions has been largely ignored or downplayed over the years by most business schools.
Hersh Shefrin, the Mario L. Belotti Professor at SCU’s Leavey School of Business, has been a pioneer in the area of behavioral finance, which examines the role the human factor plays in the business world. In a new book, Ending the Management Illusion, he talks about how companies can avoid bad decisions by making structural changes to take the human element into account.
“I’ve tried to take a look at the classic financial mistakes which people make, both as individuals and in groups and relate these to corporate culture and process — particularly when it comes to a bias toward overconfidence and optimism,” he said. “This book is not going to solve all those problems, but it can be the beginning of a conversation between managers and those of us who teach them.”
Shefrin has written an earlier book, Beyond Greed and Fear, that provided an overview of these issues for financial practitioners. Ending the Management Illusion is written for corporate managers. The tone is conversational, and the reader can almost imagine Shefrin using the text as a lecture, which he said he plans to do.
Too often, he said, managers plan only for the best-case situation and don’t rigorously identify the things that can go wrong and what the best response would be if they do. They tend to suffer from “the illusion of control,” which makes them overconfident about their ability to generate the outcome they want and reluctant to plan for possible setbacks.
“The book is not about ending management,” Shefrin said. “It’s about improving management through the use of better financial and accounting processes which are built into the culture of the organization.”
For a company to function effectively and correct its own bad impulses, there are four business processes that need to be woven into the fabric of a company’s culture. These involve accounting, planning, incentives, and information sharing. Among other things, these processes induce managers to engage in contingency planning and think through a variety of potential scenarios.
One company that integrates those four very well, he said, is Southwest Airlines. That company “manages around the numbers” and has strict accounting standards so that managers continuously track what’s going on financially. When Southwest was considering setting up at the Denver airport, its team asked so many good contingency-based questions of airport management that the airport managers realized there were some issues they themselves needed to address.
"We're on a dangerous trajectory for this planet. Business is part of the solution as well as part of the problem."
—Hersh Shefrin, the Mario Belotti Professor of Finance
In his book, Shefrin also addresses how the human tendency to succumb to illusions has affected the debate about the environment, a conspicuous example being the denial in some quarters of the reality of global warming. That affects both the political debate and the actions businesses take on environmental issues.
“We’re on a dangerous trajectory for this planet,” he said. “Business is part of the solution as well as the problem. But ending the illusion of management will help companies develop solutions. However, if managers continue in their illusions, their companies are more likely to end up being part of the problem than part of the solution.”
When Shefrin got into the field of behavioral finance three decades ago, “my professional colleagues’ reaction … lay somewhere between rejection and outright hostility,” he writes in his book. Today, it’s a different story.
“A paradigm shift is taking place,” he said. “Behavioral finance is now in the mainstream of economic thought, and financial practitioners are starting to pay attention.”