Here is a brief excerpt from an article written by Dan P. Lovallo and Olivier Sibony for the McKinsey Quarterly, published by McKinsey & Company. To read the complete article, check out other resources, learn more about the firm, obtain subscription information, and register to receive email alerts, please click here.

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Companies are vulnerable to misconceptions, biases, and plain old lies. But not hopelessly vulnerable.

The chief executive of a large multinational was trying to decide whether to undertake an enormous merger—one that would not only change the direction of his company but also transform its whole industry. He had gathered his top team for a final discussion. The most vocal proponent of the deal—the executive in charge of the company’s largest division—extolled its purported strategic advantages, perhaps not coincidentally because if it were to go through he would run an even larger division and thereby be able to position himself as the CEO’s undisputed successor. The CFO, by contrast, argued that the underlying forecasts were highly uncertain and that the merger’s strategic rationale wasn’t financially convincing. Other members of the top team said very little. Given more time to make the decision and less worry that news of the deal might leak out, the CEO doubtless would have requested additional analysis and opinion. Time, however, was tight, and in the end the CEO sided with the division head, a longtime protégé, and proposed the deal to his board, which approved it. The result was a massive destruction of value when the strategic synergies failed to materialize.

Does this composite of several real-life examples sound familiar? These circumstances certainly were not ideal for basing a strategic decision on objective data and sound business judgment. Despite the enormous resources that corporations devote to strategic planning and other decision-making processes, CEOs must often make judgments they cannot reduce to indisputable financial calculations. Much of the time such big decisions depend, in no small part, on the CEO’s trust in the people making the proposals.

Strategic decisions are never simple to make, and they sometimes go wrong because of human shortcomings. Behavioral economics teaches us that a host of universal human biases, such as overoptimism about the likelihood of success, can affect strategic decisions. Such decisions are also vulnerable to what economists call the “principal-agent problem”: when the incentives of certain employees are misaligned with the interests of their companies, they tend to look out for themselves in deceptive ways.

Most companies know about these pitfalls. Yet few realize that principal-agent problems often compound cognitive imperfections to form intertwined and harmful patterns of distortion and deception throughout the organization. Two distinct approaches can help companies come to grips with these patterns. First, managers can become more aware of how biases can affect their own decision making and then endeavor to counter those biases. Second, companies can better avoid distortions and deceptions by reviewing the way they make decisions and embedding safeguards into their formal decision-making processes and corporate culture.

Errors in strategic decision making can arise from the cognitive biases we all have as human beings.1These biases, which distort the way people collect and process information, can also arise from interactions in organizational settings, where judgment may be colored by self-interest that leads employees to perpetrate more or less conscious deceptions (Exhibit 1).

Distortions

Of all the documented cognitive distortions, overoptimism and loss aversion (the human tendency to experience losses more acutely than gains) are the most likely to lead people who make strategic decisions astray, because decisions with an element of risk—all strategic ones—have two essential components. The first is a judgment about the likelihood of a given outcome, the second a value or utility placed on it.

When judging the likelihood of potentially positive outcomes, human beings have an overwhelming tendency to be overoptimistic or overconfident: they think that the future will be great, especially for them. Almost all of us believe ourselves to be in the top 20 percent of the population when it comes to driving, pleasing a partner, or managing a business. In the making of strategic decisions, optimism not only generates unrealistic forecasts but also leads managers to underestimate future challenges more subtly—for instance, by ignoring the risk of a clash between corporate cultures after a merger.

When probabilities are based on repeated events and can therefore often be well defined, optimism is less of a factor. But loss aversion is still a concern. Research shows that if a 50–50 gamble could cost the gambler $1,000, most people, given an objective assessment of the odds, would demand an upside of $2,000 to $2,500.2Overoptimism affects judgments of probability and tends to produce overcommitment. Loss aversion influences outcome preferences and leads to inaction and undercommitment. But the fact that overoptimism and loss aversion represent opposing tendencies doesn’t mean that they always counteract each other.

Loss aversion wouldn’t have such a large effect on decisions made in times of uncertainty if people viewed each gamble not in isolation but as one of many taken during their own lives or the life of an organization. But executives, like all of us, tend to evaluate every option as a change from a reference point—usually the status quo—not as one of many possibilities for gains and losses over time across the organization. From the latter perspective, it makes sense to take more risks. Most of the phenomena commonly grouped under the label of risk aversion actually reflect loss aversion, for if we integrated most gambles into a broader set, we would end up risk neutral for all but the largest risks. This truth has important implications for strategic decision making.

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Here is a direct link to the complete article.

Dan Lovallo is a professor at the Australian Graduate School of Management of the University of New South Wales, as well as an adviser to McKinsey; Olivier Sibony is a director in McKinsey’s Paris office

Dan Lovallo would like to acknowledge the many contributions of Daniel Kahneman and Bent Flyvbjerg to the underlying ideas in this article. The authors would also like to thank Renee Dye, Bill Huyett, Jack Welch, and especially John Horn.