Capital Allocation: How to Recognize Bias in Your Decision-Making

Whether launching a new product, investing in equipment, or weighing the merits of an acquisition, CFOs typically rely on their capital planning process to help shape high-stakes decisions. Shareholders, creditors, and employees alike expect management to take this obligation seriously, and to get it right consistently.

A look at the S&P 500 suggests just how difficult it can be to consistently drive positive results, however. Take one measure, return on invested capital (ROIC). In a Deloitte study, neither the amount of capital expenditures (as a percentage of revenue) nor the growth in capital expenditure demonstrated any kind of meaningful correlation with ROIC.

Given such uncertainty, it may not be surprising that more than 60% of finance executives in a different study say they are not confident in their organization’s ability to optimally allocate capital.

Three common biases seem to stand out as likely to wreak havoc on capital decision-making: the optimism bias, expert bias, and narrow framing

Why is this? On paper, it seems practical enough for everyone throughout the organization to support the goals and priorities set at the top. However, behavioral science, and possibly your own experience, suggests it’s not always that simple. Individuals may be overly optimistic about certain courses of action, rely too much on specific pieces of information, or simply interpret the objective through too narrow a lens.

Within the behavioral science field, these are referred to as cognitive biases, specifically the optimism bias, expert bias, and narrow framing.  

While extensively covered within the academic literature, these biases are typically not as salient in matters of capital planning. Yet the evidence suggests they may be no less prevalent.

In this issue of CFO Insights – the first installment of a two-part discussion on capital allocation – we’ll dissect the attributes that can help identify these biases and highlight how they can manifest throughout the capital planning processes.

Three common biases

Biases can arise throughout many areas of daily life. From how we choose a retirement plan to picking out jams at the grocery store, we often make unconscious, sub-optimal decisions. Capital planning decisions may be no different.

From the original Nobel Prize-winning work of psychologists Amos Tversky and Daniel Kahneman to more recent findings, more than 80 different cognitive biases have been identified over the last 40 years.

Of these, three common biases seem to stand out as likely to wreak havoc on capital decision-making: the optimism bias, expert bias, and narrow framing. Here’s an in-depth look at how they typically work.

The optimism bias

Optimism, while not categorically bad, is often closely tied to overconfidence. Known to minimize uncertainty, overconfidence can lead to perilous outcomes. In his book, Thinking, Fast and Slow, Daniel Kahneman recounts a multi-year study involving autopsy results. Physicians surveyed said they were “completely certain” with their diagnosis while the patient was alive, but autopsies contradicted those diagnoses 40% of the time.

Another long-term study asked CFOs to predict the performance of a stock market index fund, along with their own company’s prospects. When asked to give an 80% confidence interval (that is, provide a range of possible outcomes they are 80% certain results will fall within), only 33% of the results actually fell within their estimates – and most miscalculated in an overly optimistic manner.

Interestingly, the same CFOs who misjudged the market, misjudged the return on investment (ROI) of their own projects by a similar magnitude.

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