Behavioral Finance is a very useful system that has developed over recent years as an attempt to explain why investors often make what seem like economically irrational investment decisions. For instance, we all know that the object is to buy low and sell high, which requires acting contrary to what most other people are doing at any given time. But such independence of judgement, while often lauded, is in fact rarely practiced. Behavioral finance helps explain why this is the case, along with examining many other behaviors. In essence, it recognizes that humans are not machines or computers, as so many other economic models seems to assume. Humans are driven by emotion as much as by intellect.
Attitude Media has developed Behavioral Management Theory to help explain why business and corporate managers make decisions which are not motivated by economic rationale. For instance, despite the well documented trend of corporate mergers to fail to produce economic value, they continue to be as popular as ever. Why? Chiefly for two reasons, neither of which can be explained by conventional economic theory:
1) Expanding a company through acquisitions is more interesting work for top managers than the day to day business of running existing operations or trying to expand organic growth.
2) Buying other companies, and expanding the size of their own companies, makes managers feel more important, even though such acquisitions are unlikely to actually increase profits for the acquiring company. In many ways, top executives buy companies for the same reasons that people who have lots of shoes buy more shoes. They enjoy the shopping process, and they like having lots of shoes. No one would argue that buying more shoes helps the purchaser economically, although it may very well help the shoe manufacturer, and also the shoe salesman. CEO’s like buying companies, and investment bankers are happy to encourage this process.
In addition to buying companies, top managers can also try to create new products within their own companies. This might seem to make more sense than outside acquisitions, but the economic logic is equally dubious except when the type of product being developed is well within a company’s core competency. No matter the company, the vast majority of internal product development projects fail to produce profitable products. Of course, one could argue that there is economic logic here, the same sort of logic that venture capital and media firms use: While most products may fail, the ones that make money become so profitable as to cover the costs of the failures. For every 10 investments a VC firm makes, 7 or 8 will never make money, 1 or 2 will break even or make a little money, but hopefully one will be a huge success; the company that becomes Facebook or Amazon or Google will make so much money for its founders that the profits will overwhelm the losses from the ones that failed. This sort of logic is also true for media companies; the vast majority of books, movies, plays, musical albums, and apps never make money. But the few media products that do make money, tend to make quite a lot as compared to their development costs.
But the reality is that no economically based logic can really explain product development. Entrepreneurial managers like making new things – they don’t particularly like the grind of running businesses. Jeff Bezos founded Amazon, still runs the company and is a billionaire many times over – he cares about the stock price, but only because a rising stock price keeps investors off his back and gives him more leeway to spend money on new product development. It will not affect his own lifestyle in the least as to whether his share of Amazon stock is worth $5 billion or $500 million; in any case he’ll have far more money than he or his family will use for personal consumption. But he very much enjoys making new products. So the fact that Amazon spent, and lost, $170 million on developing their own phone was defended by the company on economic grounds. As the CEO, Bezos generally has an obligation to maximize the economic returns for Amazon shareholders. But the real reason Amazon develops so many new products has nothing do with economics and everything to do with the sort of work Jeff Bezos finds interesting.
Bezos and Amazon have developed a vast array of products – cloud servers, third party market places, third party advertising, markets for every type of product known to man, cell phones, music and video services, delivery via drone, search, auctions, payment services, and many more. But despite all this, his curiosity cannot be contained within Amazon. He started a space company (Blue Origin), patented an air bag system for phones, and spent $250 million of his own money to buy the Washington Post newspapers, part of a floundering industry that would seem like a full time job for anyone else – Bezos did this as a hobby and a personal “investment”.
The same phenomenon can be seen at Google, and countless other companies. Googles’ biggest success and the source of the vast majority of their revenues is, of course, online search. There is also Gmail for email, Google+ and Buzz for social networking, the Android operating system for mobile phones, Google Docs for document sharing, Google Earth maps, Wave to combine different types of conversations, YouTube, Glass wearable devices, the self-driving car and many more. Most of these have not increased profits, but there is no indication that Google has any intention of slowing down product innovation. Of course, there are some sound business reasons for innovations that don’t make money; even failed products generate publicity for the company, some products don’t make money but encourage more use of other Google products, it’s easier to hire the best and the brightest if you encourage innovation, and so on. But none of this should obscure the basic truth that what really drives new product development is not the alleged search for greater profits, but the fundamental desire of Google’s founders and management to create cool new things.
The desire to try new things is by no means limited to American tech entrepreneurs. British serial entrepreneur Richard Branson has been involved in a stunning array of businesses, mostly through his Virgin companies empire encompassing over 400 businesses: music, an airline, food and beverage, media and telecommunications, financial services, hotels, health care and much more.
Branson has explicitly said that the desire to have fun is a motivating factor:
“I can honestly say that I have never gone into any business purely to make money. If that is the sole motive, then I believe you’re better off not doing it. The business has to be involving, it has to be fun, and it has to exercise your creative instincts.”
So when you invest in a company, you should understand that, while your goal is to make money, those actually running the company may care very little about making more money, although they will rarely admit this. It’s very rare to find the CEO of a publicly traded company who is willing to say “We used $400 million of our company’s cash to try to build this really cool new product. No idea if it will ever make money, but it was a lot more interesting trying to make something new than spend time on the old stuff”. But that statement would often be the truth.
There are all sorts of other management actions that can also best be seen through the prism of behavioral management:
Managers will use the company’s money to make non-profit donations in order to feel good about themselves or advance their own or their spouses, social agendas.
Managers will get their companies involved in “glamorous” businesses like the media because they find such businesses “sexier” and more interesting than other businesses, despite the fact that the economics of most media businesses are poor. Along the same lines, managers will use company money to become involved in such businesses to improve their sex or social lives. Many film investments are better understood as premiums paid by male managers to meet actresses than as legitimate business investments.
Managers often use the term “synergy” to describe the benefits that will come from combining an existing business with a new acquisition. Such “synergies” rarely pan out, but they do provide an excuse for managers to pay too much to enter an interesting new field.
So when you hear any manager or executive talk about a new product development or acquisition, or a donation to a non-profit, it really makes sense to think about why they’re really doing this? They will always talk about revenue, or profits or synergies, but it’s rarely really about revenue and profits, and even rarer for the new product or acquisition to actually increase profits.