Engineered

Robert Merton on Innovation Risk

Nobel Laureate in Economics and MIT professor Robert Merton has written an excellent article on Innovation Risk in the April issue of Harvard Business Review. Here’s one of the most valuable excerpts, which gives a good high-level overview of the whole article: “Some models turn out to be fundamentally flawed and should be jettisoned, while others can be improved upon. Some models are suited only to certain applications; some require sophisticated users to produce good results. And even when people use appropriate models to make choices… it is almost impossible to predict how their changed behavior will influence the riskiness of other choices and behaviors they or others make.” If you only care to remember three sentences about decision-making, make it those three. You’ll already be ahead of the pack.

I also liked Merton’s brief discussion of the Black-Scholes formula in option pricing, which he helped develop, the 2007-2009 financial crisis, which he mentions to illustrate unintended consequences, and his use of pi to make his point about models: for instance, using a value of 4.14 for pi is clearly wrong (although incorrectness may be difficult to spot), while a value of 3.14 or 22/7 is simply incomplete, but may be appropriate in applications such as high school exercises.

He also makes a valuable aside in a side box about the credit-rating debacle, a good example of “how adopting a model not fit for your purpose – in this case, using a model for predicting the likelihood of default rather than one for valuing bonds to manage the portfolio – can result in disastrous decisions.” Another side box focuses on systemic risk.

Merton’s framework can be summarized in the following five steps:

1. Recognize that you need a model for making judgments about risk and return,
2. Acknowledge your model’s limitations,
3. Expect the unexpected,
4. Understand use and user (“A model’s utility depends not just on the model itself but on who is using it and what they are using it for… A model is also unreliable if the person using it doesn’t understand it or its limitations.”),
5. Check the infrastructure, i.e., the environment into which an innovation is introduced.

This will without a doubt emerge as one of the most important HBR articles of the year.

Book review: "Decisive" by the Heath brothers

Some time ago I read “Switch: How to Change Things when Change is Hard” by the Heath brothers (Chip and Dan) and reviewed it on this blog. My post started as follows: “Here is my one-sentence review: The book is so good I feel sorry the authors have to sell it at the same price as the other hardcovers out there. If that's enough to convince you to give it a try, great. Otherwise, read on.”

I wasn’t quite sure I’d like “Decisive” as much. I felt that the topic (how to make better decisions) was less original, the green cover of the book is simply hideous, and the introduction, which I’d read before the release date, just didn’t grab me. But the preview I got included Chapter 1, not just the introduction, which meant I got to read the story about the brown M&Ms that a rock star had set as a “tripwire” for his national tour (to figure out whether people had read the contract full of technical specs he’d made them sign, with severe safety implications for his crew) and “Switch” was truly very good. So I bought the book.

And enjoyed it immensely. Now, for me “Switch” was a six-stars-out-of-five sort of book, and “Decisive” doesn’t rise to that level, but I give it a solid five stars nonetheless. I still had that feeling of being sorry for the authors that they have to sell their books at the same price as the other hardcovers out there, especially the puffed-up magazine pieces that find their way into bookstores these days. Also, while the topic of making better decisions has received significant attention, the Heath brothers do manage to give fresh insights and make the reader re-think his or her approach to looming big decisions ahead. In other words: “Decisive” is a much-needed book, and it delivers.

The book is centered on a 4-step framework to avoid common unconscious biases in decision-making: the WRAP process. (They’re business experts. Of course they had to have an acronym for their method.) Below I provide the four parts of WRAP and keywords for some (but far from all) ideas that the Heath brothers give in their book:

• Widen your options
  • Think AND not OR
  • Run the “vanishing options test” (if the options you’ve thought about so far weren’t available/allowed, what would you do?)
  • Toggle between the promotion and prevention mindsets (if you had suddenly more time/money, how would you spend it? what if there was a severe cutback?)
  • Find someone who has solved your problem
• Reality-test your assumptions
  • Ask disconfirming questions
  • Consider the opposite
  • Zoom out: respect the base rates (for instance in a medical situation: what are the averages?)
  • Zoom in: take a close up (for instance, the reviews on a website like Yelp might be summarized into a lackluster average, but if you analyze them more carefully, you may realize people either love or hate the restaurant for specific reasons that may not be relevant to you)
  • “Ooch” into it (as in: lean into it, although the authors caution against “emotional tiptoeing”, which is used to delay commitments)
• Attain distance before deciding
  • Try 10/10/10 (how will you feel about it in 10 minutes? 10 days? 10 months?)
  • Fight the “status quo bias”
  • Shift perspectives to gain distance (imagine it’s not you but your best friend who has to take the decision – what would you tell your best friend to do? And at work, imagine you’ve been replaced and ask the “Andy Grove question”: what would your successor do?)
  • Identify your core priorities to resolve dilemmas (what would an outside investigator conclude about your priorities by reading your calendar?)
• Prepare to be wrong.
  • Create a “realistic job preview” (what are problems people in this situation often encounter?)
  • Set a tripwire (for instance a deadline by which something must have happened, or you’re switching to Plan B)
  • Run a premortem and preparade (you’ll have to read the book to understand what that means)
  • And more!

If you’re still on the fence regarding the book, you can download free resources to make better decisions by signing up on the Heath Brothers’ website. I can attest that they email their list very rarely, and only with relevant information, so readers definitely get the best of that bargain, given the great resources – podcasts and summary sheets – available for download upon registration. (It’s because I had signed up after I read “Switch” that I got a sneak peek into “Decisive”.) SSIR - Stanford Social Innovation Review - also has an excerpt of the book here.

In summary: “Decisive” is not quite as earth-shattering as “Switch,” less profound research, but far better than 99% of the business books out there.

The New Where and How of Innovation

Today’s (short) post is about two articles in the September 2012 issue of Harvard Business Review. The first one, “The New Corporate Garage”, discusses the places “where today’s most innovative – and world-changing – thinking is taking place”. The main argument of that article is that we have entered innovation’s fourth era, after the eras of (1) the lone inventor, (2) corporate labs and (3) venture-capital-backed startups. In this new era, the author states, “the scale of a big company can unleash innovation” thanks to “passionate, entrepreneurial catalysts who use corporations’ global infrastructure, brand reputation, partner relationships, process excellence and other capabilities to develop solutions to global challenges in ways that few others can.”

The article provides the following examples:

• Medtronic’s Healthy Heart for All
• Unilever’s Water Purification
• Syngenta’s Productive Farming
• IBM’s Smarter Cities.

These companies “mixed the entrepreneurial approach of a third-era VC-backed start-up with the unique capabilities once housed in second-era corporate labs” and leveraged their advantages to achieve results start-ups would be hard-pressed to replicate. The author is careful to emphasize these successes would not have been possible without corporate catalysts, “those mission-driven leaders who corral corporate resources that are outside their traditional span of control to address sprawling challenges.”

Another interesting article in the same HBR issue was “Are you solving the right problem?” with the subtitle “Most firms aren’t, and that undermines their innovation efforts.” I particularly liked that article because it is based on a framework developed by InnoCentive, the online innovation marketplace, and uses concrete examples of how well-defined problems have led to once-elusive solutions, for instance:

• cleaning the 1989 Exxon Valdez spill in spite of the low temperatures (which hindered traditional pumping) by framing the problem as one of “materials viscosity”,  
• identifying the stage and progression of the disease in any patient by using a noninvasive biomarker, instead of trying flat-out to cure ALS (Lou Gehrig’s disease),
• predicting solar flares with better accuracy by recasting the problem as a data-driven and forecasting challenge, which led to a solution by a semi-retired engineer whose model provided 85% accuracy with an 8-hour lead time (instead of 50% and 4 hours in the previous NASA model).

Hybrid Organizations

I wrote in March about the rise of a new type of business, which combines aspects of for-profit companies and of nonprofits to reflect an increased sense of corporate social responsibility among companies. For today’s post, I thought I’d mention articles I read on the topic not too long ago, all from the Stanford Social Innovation Review.

The first one, “In search of the hybrid ideal” (Summer 2012), describes the results of a Harvard Business School study (done in partnership with Echoing Green), whose purpose was to better understand these new models, in recognition of the “trend among social innovators toward creating hybrid organizations that primarily pursue a social mission but rely significantly on commercial revenue to sustain operations.” Because such a structure is so novel, hybrid companies face distinct challenges due to the lack of a supporting ecosystem and the risk of mission drift.

The article lists four broad types of issues:

1. Legal structure (New legal structures in the US include the L3C – low-profit limited liability company – the Benefit Corporation and the Flexible Purpose Corporation, but they are not available in all states.)
2. Financing (hybrids don’t have a clear path to funding and often experience difficulties in raising capital, but an increase in impact investing would certainly help them)
3. Customers and beneficiaries (both need to be differentiated in the hybrid model, since the beneficiaries usually cannot afford to pay for the full price of the product transacted.)
4. Organizational culture and talent development (hybrids must foster a specific culture to thrive, and “because hybrid organizations are not widespread, job candidates with extensive experience or training in hybrid working environments typically do not exist”, so the authors recommend to hire young people right out of school and train them.)

In the Fall 2012 issue, “The truth about Ben and Jerry’s” claims that, “contrary to myth, the sale of Ben and Jerry’s to corporate giant Unilever wasn’t legally required.” While proponents of the new legal structures such as the B-Corporation claim that they would have prevented the sale if they had existed back then,

• the author of the article points out that “the best and arguable support for this view [that corporate directors must always act to maximize shareholder value] is from Dodge v Ford, a 1919 decision from the Michigan Supreme Court… [but] other courts have not followed its view of shareholder primacy.” (Background information on the case can be found here.)
• he quotes a Cornell Law professor, Lynn Stout, as saying that “shareholder maximization is not a modern legal principle” (you can read her essay on the topic on the SSRN website),
• the New Jersey Supreme Court has stated, according to the author, that “modern conditions require that corporations acknowledge and discharge social as well as private responsibilities as members of the community within which they operate.”
• the author also mentions that some state legislatures have enacted statutes that “expressly authorize corporate directors to look beyond shareholder wealth maximization” (they are called “other constituency” statute in Vermont, for instance).

The author’s point is that the much-touted new forms for social entreprises are not actually necessary, although he concedes that they may help reinforce perception that a company will not pursue profit maximization above all.

Finally, “Bettering the Used Book Business” provides a real-life example of a successful hybrid company, Better World Books (BWB), which “has found a way to make a profit and donate more than $11 million for literacy programs and libraries worldwide.” From its inception in 2003 by two University of Notre-Dame graduates, the company was set up as “a for-profit company with a social purpose – to sell books to finance literacy programs.” BWB now employs 350 people and has been profitable for the past 3 years; it has also partnered with 5 literacy programs. It receives 100,000 books at its Indiana warehouse every week (mainly from book drives) and “donates 7 to 10 percent of its sales proceeds to its nonprofit literacy partners.” (If a library donates a book, it receives 15 percent of the book’s net sale.)

I was impressed by the sophistication of its analytics software which, when an ISBN is scanned, makes a decision based on past historical data, of “whether to put the book into its for-sale inventory, donate it, or recycle it.” Because of its B-Corp status, the company is required to “provide documentation every two years on how its operations aid all its stakeholders, not just its shareholders.” Such hybrid models are important to attract talented employees who might be reluctant to step into the nonprofit world but want to feel the work they do serves a good cause. You can find more info on Better World Books here. I know where I'll be sending my books!

HBR on Mitigating Strategic Risk

The June issue of Harvard Business Review had an article on "Managing Risks: A New Framework" by Robert Kaplan (of Balanced Scorecard fame) and Anette Milkes. In it, the authors argue against the belief that "risks can be managed by establishing and following rules, standards and guidelines", as they repeat in a HBR blog post they wrote after JP Morgan's losses in its Chief Investment Office in London - the losses, brought about in the famous "London whale" case, could reach $9bn. ("Not all losses are failures of risk management — unless we expect to take no risk at all... [A] large loss in itself is not evidence of a risk management failure, because a large loss can happen even if risk management is flawless".)

The authors distinguish between three types of risk: preventable risks, strategy risks and external risks. They comment that "while a compliance-based approach is effective for managing preventable risks, it is wholly inadequate for strategy risks or external risks, which require a fundamentally different approach based on open and explicit risk discussions."

The authors advocate the use of independent experts, facilitators and/or embedded experts. They also make the case for the following tools:

• for strategy risks, interactive discussions about risks using maps of likelihood and impact of identified risks and key risk indicator scorecards, resource allocation to mitigate critical risk events,

• for external risks, "envisioning" risks through tail-risk assessments and stress testing, scenario planning and war gaming.

They talk about probabilities here and there, but overall I found the disregard for quantitative tools a bit annoying, as if managers didn't need to put in place contingency plans to, say, satisfy customer demand, no matter where the disruption will take place. (Or as if the uncertainty underlying them didn't need to be mitigated using analytical tools.)

Instead, we're treated to color-coded risk event cards and risk report cards, which come across as trying to make uncertainty palatable to managers who aren't trained in decision-making under uncertainty. Maybe in this day and age it is time to say that everybody interested in risk management should exhibit enough familiarity with randomness that you don't have to "prettify" things by color-coding them to shove probabilities down the throat of decision-makers.

The article itself explains: "The benefits from stress-testing... depend critically on the assumptions - which may themselves be biased - about how much the variable in question will change. The tail-risk stress tests of many banks in 2007-2008, for example, assumed a worst-case scenario in which US housing prices leveled off and remained flat for several periods." This should serve as a reminder of the pressures exerted on risk management groups because their cautious, downside-focused approach will always stand in the way of the upside-focused methods favored by the rest of the company. In turn, this will always result in pressure to consider overly optimistic assumptions. This is not the fault of the quantitative models, but of the very human people who implement them (or oversee said very human people).

Indeed, the authors state: "A firm's ability to weather storms depends on how seriously executives take risk management when the sun is shining and no clouds are on the horizon." A more in-depth mention of relevant quantitative techniques and analytics would have helped, besides the mentions of scenario planning and war gaming. It's tempting to conclude from the article that the environment is so uncertain you can't really use anything quantitative, when in fact the risk report card has numerical values for assessed risks and critical risks (with color-coded arrows for the trends). The article should become a reference for managers who have developed an interest in risk management while in "qualitative-driven" careers, but might be found lacking by managers who already possess quantitative skills.

The authors are right to say, though, that the purpose of risk management is to "neutralize their managerial bias of seeing the world as they would like it to be rather than as it actually is or could possibly become."

Further readings:

• "Six mistakes executives make in risk management"
• "A framework for risk management"

Do you know your cost of capital?

The July/August issue of Harvard Business Review had an outstanding article ("Do you know your cost of capital?") on how the assumptions that leaders make can affect their cost of capital. In a nutshell, the article explains that "companies differ widely in the assumptions built into the financial models they use to evaluate investment opportunities... Not a single question about such assumptions received the same answer from a majority [>50%] of respondents."

Here are some highlights:

• What's your forecast horizon? 46% answered 5 years, 34% 10 years, 6% 15 years and 14% other.
• What's your cost of debt? 37% answered current rate on outstanding debt, 34% forecasted rate on new issuance, 29% average historical rate.
• What's the risk-free rate? 46% answered 10 years, 16% 90 days, 12% 5 years, 11% 30 years, 6% other, 5% 1 year and 4% 20 years.
• What's the equity-market risk premium? 49% answered 5%-6%, 23% 3%-4%, 17% 7% or greater and 11% less than 3%.
• What's your beta period? 41% answered 5 years, 29% 1 year, 15% 3 years, 13% 2 years and 2% other.
• What's your debt-to-equity ratio? 30% answered current book debt to equity, 28% targeted book debt to equity, 23% current market debt to equity and 19% current book debt to current market equity.

The article provides insights into what the correct answers should be, and hopefully corrects some misconceptions. Readers can visit this HBR-sponsored website (hosted by forio.com, which builds custom simulations and sells simulation development software to businesses, universities and government agencies) to test out their own data and calculate their cost of capital.

HBR's "Selling into Micromarkets"

Today's post is about an article that appeared in the July/August issue of Harvard Business Review: "Selling into Micromarkets: How to use big data to uncover lucrative new hot spots." It starts with an example at an unnamed chemical and service company, which "diced its seven US regions into 70 micromarkets and zeroed in on those with the greatest potential," leading to a twofold increase in the sales growth rate "without an increase in marketing or sales costs."

The article continues: "The key to the firm's remarkable turnaround was its new ability to combine, sift and sort vast troves of data to develop a highly efficient sales strategy." Apparently, "B2B sales organizations have only recently begun to use big data to both inform overall strategy and tailor sales pitches for specific customers in real time" and the thesis of the article is that "micromarket strategy is perhaps the most potent new application of big-data analytics in B2B sales."

The strategy it describes involves three steps: (1) find new pockets of growth, (2) make it easy for the sales team (align sales coverage with opportunity, create sales plays for each type of opportunity, support the sales force in executing the plays) and (3) put data at the heart of sales (through performance management, cross-functional collaboration and talent development).

Other articles I enjoyed in that HBR issue include:

• "Expanding the entrepreneur class"
• "Dupont's CEO on executing a complex cross-border acquisition"
• "The view for the field: six leaders offer their perspectives on sales success"
• "Disrupt yourself"

and if you must only read one article from HBR, make it "Do you know your cost of capital" (more about that in my post next week).

Pricing at the Olympic Games

One of the best articles I’ve read on revenue management in a long time is in the June issue of Harvard Business Review: “Pricing to Create Shared Value”, by Marco Bertini and John Gourville. I found the article itself very interesting, but the case study on the London Olympics really stood out. The authors use it to demonstrate how their five principles can be put in action.

• Focus on relationships, not transactions. The Olympic committee “increased the number of pricing tiers for many sports, which kept some ticket prices low while hitting revenue targets,” among other policies.
• Be proactive. The “committee’s decision not to bundle tickets to a more popular sport (swimming, say) with those to a less popular sport (tae kwon do, for instance)” was motivated by the fact that people who had purchased bundles in previous Olympics often let the ticket to the secondary event go to waste, thus leading to empty seats in the event venue and wasted capacity. On the other hand, the committee did bundle public transportation into the ticket price to reduce traffic congestion.
• Put a premium on flexibility. “The committee increased the number of price tiers across events… but did not assign a fixed number of seats to each tier. It did, however, promise that someone paying more would have a better view of the event than someone paying less.” This allowed the committee “the flexibility to better satisfy actual rather than anticipated demand.” (I found that part truly fascinating. Adaptable optimization in action.)
• Promote transparency, i.e., repeatedly communicating the details of the pricing scheme to consumers in the media.
• Manage the market’s standards for fairness. For instance, “ticket allocation was carried out through a simple lottery, reinforcing the fact that there was no preferential treatment.”

Customized Leadership Development

My favorite article in the June 2012 issue of Harvard Business Review was the one by Marcus Buckingham, author of the best-selling book “Now, discover your strengths”, who wrote on “Leadership Development in the Age of the Algorithm.”

He makes the point that, although by now “personalized content [is] routinely served up by online retailers and news services on the basis of insights they’ve accumulated about you”, such customization is absent from most leadership development programs. Instead, such programs are usually based on a formulaic, one-size-fits-all approach, which “tries to collect all the various approaches to leadership, shaves off the weird outliers and packages the rest into a formula.”

Buckingham advocates for a change and describes his experience on a project he ran for Hilton Hotels, based on the insights that “if you’re a leader, authenticity is your most precious commodity, and you’ll lose it if you attempt techniques that don’t fit your strengths” and “you’ll learn best from leaders whose strengths match yours.”

Buckingham’s customized model has five steps.

1. Choose an algorithmic assessment to evaluate respondents. For instance, his “analysis showed that the range of behaviors seen across those thousands of people could be divided into nine categories, which we call strength roles.”
2. Give the assessment to the company’s best leaders. Here, Buckingham “discovered a broad distribution across all nine roles.” He then “identified a number of exceptional leaders in each category and set out to learn what fueled their success.”
3. Interview a cross section of leaders to discover their techniques.
4. Use the algorithm to target techniques to the right people. “Companies should… feed each [developing leader] practices derived from excellent leaders who have the same top two strength roles.”
5. Make the system dynamically intelligent. “Intrinsic to the notion of a personalization algorithm is that it must get to know you better over time… becomes smarter about which techniques to feed you.”

This model has the potential to “accommodat[e] the uniqueness of each leader’s techniques” while “permit[ting] the training of hundreds of leaders at once but dynamic enough to incorporate and distribute new practices and other innovations in real time.”