In its simplest form, prospect theory, originally pioneered by Kahneman and Tversky, explains why people make decisions to minimize loss rather than to achieve the highest expected value.
In a classic example consider two problems:
You are given $1000 and asked to pick one of two gambles:
A) 50% chance of winning $1000
B) $500 for sure
You are given $2000 and asked again to pick one of two gambles:
A) 50% chance to lose nothing
B) Losing $500 for sure
For the majority of survey respondents, in the first event they chose to gain $500 for sure, but when the event is framed as a loss, they chose to gamble. This is because of loss-aversion that is exhibited once you have a set reference point. The chance to avoid a loss becomes more tempting because we are so averse to losing once we have the $2000 in our possession even though the expected values of the gambles are identical.
Some day-to-day observations regarding leadership decisions while working in a public company seem to be neatly explained with prospect theory. Of these observations is the cultish obsession with revenue and EBITDA at my company. While financials reflect some measure of success, upper management has come to worship them as harbingers of life and death. One of the challenges that I have faced is the battle against upper management on whether to prioritize long-term goals vs short-term gains. In the losing battle I wage, I have seen time and time again a shift in prioritization from long-term progress to short-term goals. The idea of reference points and loss-aversion within prospect theory provide a possible explanation for these sub-optimal decisions.
Prior to an IPO, a company is often in a mode where they may be pre-revenue or unprofitable. A monetary loss may not be important and can be offset by a more intangible resource gain within the company. Without public reporting, the reference point for the company is more fluid and changes with the needs of the company. The challenge of an IPO is that once a monetary reference point is set, these intangibles which may help the company in the future may become undervalued as they are not counted in the bottom line. The correct time for an IPO often comes when companies are growing the fastest and striving to become more profitable, exacerbating the possibility of missing projections and entering the realm of “loss”. In a public company, the focus is completely different with forecasting and quarterly announcements of targets. These promises become reference points set in stone for leadership and, when faced with the danger of missing the numbers, loss-aversion pushes decisions that will sacrifice anything to avoid losses. These initiatives tend to be ones that prioritize short-term revenue and padding while ignoring long-term impacts.
A second symptom of this creates an obsession with quantifying initiatives with a revenue/margin impact. This focus often de-prioritizes long-term initiatives because they often do not have immediate revenue boosts and are more resource intensive. Thus, by avoiding the losses based on a public reference point in a public company, leadership will trade the long-term gains for short-term value.
I believe that strong leadership is able to avoid these pitfalls, whether by understanding the economic concepts that drive their decisions, or by having a broader sense of what is good and bad for the company. As of yet I am still on the lowest rung of the corporate ladder; however, I do wonder if understanding these models can make us immune to their pitfalls. Perhaps that would be an interesting experiment to conduct!