shareholder value | Human-Centered Change and Innovation

We Must Stop Worshiping Algorithms

GUEST POST from Greg Satell

In 1954 the economist Paul Samuelson received a postcard from his friend Jimmie Savage asking, “ever hear of this guy?” The ”guy” in question was Louis Bachelier, an obscure mathematician who wrote a dissertation in 1900 that anticipated Einstein’s famous paper on Brownian motion published five years later.

The operative phrase in Bachelier’s paper, “the mathematical expectation of the speculator is zero,” was as powerful as it was unassuming. It implied that markets could be tamed using statistical techniques developed more than a century earlier and would set us down the path that led to the 2008 financial crisis.

For decades we’ve been trying to come up with algorithms to help us engineer our way out of uncertainty and they always fail for the same reason: the world is a messy place. Trusting our destiny to mathematical formulas does not eliminate human error, it merely gives preference to judgements encoded in systems beforehand over choices made by people in real time.

The False Promise Of Financial Engineering

By the 1960s a revolution in mathematical finance, based on Bachelier’s paper and promoted by Samuelson, began to gain momentum. A constellation of new discoveries such as efficient portfolios, the capital asset pricing model (CAPM) and, later, the Black-Scholes model for options pricing created a standard model for thinking about economics and finance.

As things gathered steam, Samuelson’s colleague at MIT, Paul Cootner, compiled the most promising papers in a 500-page tome, The Random Character of Stock Market Prices, which became an instant classic. The book would become a basic reference for the new industries of financial engineering and risk management that were just beginning to emerge at the time.

However, early signs of trouble were being ignored. Included in Cootner’s book was a paper by Benoit Mandelbrot that warned that there was something seriously wrong afoot. He showed, with very clear reasoning and analysis, that actual market data displayed far more volatility than was being predicted. In essence, he was pointing out that Samuelson and his friends were vastly underestimating risk in the financial system.

Leading up to the Great Recession, other warning signs would emerge, such as the collapse of LTCM hedge fund in 1998 and of Enron three years later, but the idea that mathematical formulas could engineer risk out of the system endured. The dreams turned to nightmares in 2008, when the entire house of cards collapsed into the worst financial crisis since the 1930s.

The Road To Shareholder Value

By 1970, Samuelson’s revolution in economics was well underway, but companies were still run much as they were for decades. Professional managers ran companies according to their best judgment about what was best for their shareholders, customers, employees and the communities that they operated in, which left room for variance in performance.

That began to change when Milton Friedman, published an Op-Ed in The New York Times, which argued that managers had only one responsibility: to maximize shareholder value. Much like Bachelier’s paper, Friedman’s assertion implied a simple rule-of-thumb with only one variable to optimize for, rather than personal judgement, should govern.

This was great news for people managing businesses, who no longer had to face the same complex tradeoffs when making decisions. All they had to worry about was whether the stock price went up. Rather than having to choose between investing in factories and equipment to produce more product, or R&D to invent new things, they could simply buy back more stock.

The results are now in and they are abysmal. Productivity growth has been depressed since the 1970s. While corporate profits have grown as a percentage of GDP, household incomes have decoupled from economic growth and stagnated. Markets are less free and less competitive. Even social mobility in the US, the ability for ordinary people to achieve the American dream, has been significantly diminished.

The Chimera Of “Consumer Welfare”

The Gilded Age in America that took place at the end of the 19th century was a period of rapid industrialization and the amassing of great wealth. As railroads began to stretch across the continent, the fortunes of the Rockefellers, Vanderbilts, Carnegies and Morgans were built. The power of these men began to rival governments.

It was also an era of great financial instability. The Panic of 1873 and the Panic of 1893 devastated a populace already at the mercy of the often avaricious tycoons who dominated the marketplace. The Sherman Antitrust Act of 1890 and the Clayton Antitrust Act of 1914 were designed to re-balance the scales and bring competition back to the market.

For the most part they were successful. The breakup of AT&T in the 1980s paved the way for immense innovation in telecommunications. Antitrust action against IBM paved the way for the era of the PC and regulatory action against Microsoft helped promote competition in the Internet. American markets were the most competitive in the world.

Still, competition is an imprecise term. Robert Bork and other conservative legal thinkers wanted a simple, more precise standard, based on consumer welfare. In their view, for regulators to bring action against a company, they had to show that the firm’s actions raise the prices of goods or services.

Here again, human judgment was replaced with an algorithmic approach that led to worse outcomes. Over 75% of industries have seen a rise in industry concentration levels since the late 1990s, which has helped to bring about a decline in business dynamism and record income inequality.

The Chimera Of Objectivity

Humans can be irrational and maddening. Decades of research have shown that, when given the exact same set of facts, even experts will make very different assessments. Some people will be more strict, others more lenient. Some of us are naturally optimistic, others are cynics. A family squabble in the morning can affect the choices we make all day.

So it’s not unreasonable to want to improve quality and reduce variance in our decision making by taking a more algorithmic approach by offering clear sets of instructions that hold sway no matter who applies them. They promise to make things more reliable, reduce uncertainty and, hopefully, improve effectiveness.

Yet as Yassmin Abdel-Magied and I explained in Harvard Business Review, algorithms don’t eliminate human biases, they merely encode them. Humans design the algorithms, collect the data that form the basis for decisions and interpret the results. The notion that algorithms are purely objective is a chimera.

The problem with algorithms is that they encourage us to check out, to fool ourselves into thinking we’ve taken human error out of the system and stop paying attention. They allow us to escape accountability, at least for a while, as we pass the buck to systems that spit out answers which affect real people.

Over the past 20 or thirty years, we’ve allowed this experiment to play out and the results have been tragic. It’s time we try something else.

— Article courtesy of the Digital Tonto blog
— Image credit: Google Gemini (NanoBanana)

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The Shareholder Value Myth

GUEST POST from Greg Satell

The Business Roundtable, an influential group of almost 200 CEOs of America’s largest companies, a few years ago issued a statement that discarded the old notion that the sole purpose of a business is to provide value to shareholders. Instead, it advocated serving a diverse group of stakeholders including customers, employees, suppliers and communities.

The idea is not a new one. In fact, Jack Welch once called shareholder value the dumbest idea in the world. Nevertheless, The Wall Street Journal opinion page immediately pounced, suggesting that the move was just an attempt to “appease the socialists” and that it would undermine financial accountability.

It’s hard to see how acknowledging accountability to stakeholders other than investors would undermine accountability to investors. Shareholders, after all, have the power to fire CEOs. Even more importantly though, the notion that performance can be reduced down to a single metric is foolhardy and dangerous. Managing a business is simply tougher than that.

The Principal-Agent Problem

Every business seeks to make a profit. Ones that do not achieve that basic requirement do not stay in business for long. However, that doesn’t mean that the only reason a business exists is to make money. Clearly, in order to earn a profit over the long term, you need to provide value for others. Anybody who has ever run a business knows this.

Yet a large corporation is very different from an ordinary business in that there is what’s known as a principal-agent problem. The shareholders are a dispersed group that have relatively little information, while the managers of the business are a small group with an asymmetric informational advantage.

So you can see how the concept of shareholder value can be attractive. If you can reduce performance down to a single metric, such as stock performance, then the principal-agent problem is solved. Shareholders, as principal owners of the company, can hold managers, as their agents, accountable.

Yet this is a fantasy. There are many things that a manager can do, such as reducing investment or making a lot of sexy acquisitions, that can increase short-term financial performance, but hurt performance in the long run. So the concept of shareholder value has always been a murky one.

From Value Chains To Ecosystems

For decades, the dominant view of strategy was based on Michael Porter’s ideas about competitive advantage. In essence, he argued that the key to long-term success was to dominate the value chain by maximizing bargaining power among suppliers, customers, new market entrants and substitute goods.

Yet there was a fatal flaw in the notion that wasn’t always obvious. In an industrial economy, where technology is relatively static, value chains are stable. However, in a fast moving information economy, firms increasingly depend on ecosystems to compete. That drastically changes the game.

Ecosystems are nonlinear and complex. Power emanates from the center instead of at the top of a value chain. You move to the center by connecting out. So while an industry giant may possess significant bargaining power, exercising that bargaining power can be problematic, because it can weaken links to other nodes in the ecosystem.

So the increased emphasis on stakeholders is not merely some newfound socialistic altruism, but a realistic strategic shift. In a networked-driven world you need to continually widen and deepen links to other stakeholders within the ecosystem. That’s how you gain access to resources like talent, technology and information.
Building Power Through Gaining Trust

In a famous 1937 paper, Nobel Prize winning economist Ronald Coase argued that the function of a firm was to minimize transaction costs, especially information costs. For example, it makes sense to keep employees on staff, even if you might not need them today, so that you don’t need to search for people tomorrow when a job comes in.

Another way to minimize transaction costs is through building trustful relationships. If the stakeholders within ecosystems that you operate trust you, you gain greater access to information and decrease the amount of resources you need to spend on enforcing formal and informal norms. In fact, a study from Accenture Strategy recently found that building trust with stakeholders is increasingly becoming a competitive advantage.

In The Good Jobs Strategy MIT’s Zeynep Ton found that investing more in well-trained employees can actually lower costs and drive sales in the low-cost retail industry. While the sector is often thought of as highly transactional, her research indicates that a dedicated and skilled workforce results in less turnover, better customer service and greater efficiency.

For example, when the recession hit in 2008, Mercadona, Spain’s leading discount retailer, needed to cut costs. But rather than cutting wages or reducing staff, it asked its employees to contribute ideas. The result was that it managed to reduce prices by 10% and increased its market share from 15% in 2008 to 20% in 2012.

In other cases, competitors collaborate to improve their industrial ecosystems for customers. So it is should not be surprising that firms are increasingly investing in structures that are focused on ecosystems, such as Internet of Things Consortium, Partnership on AI and the Manufacturing Institutes. Again, power in an ecosystem resides at the center, not at the top, so to compete you have to connect.

Clearly, it could be argued that by investing in these partnerships, business are increasing shareholder value. However, to do so would be to essentially argue that investing in stakeholder ecosystems and pursuing shareholder value are equivalent, which reduces the debate to one of semantics rather than substance.

Manage For Mission, Not For Metrics

Perhaps one of the most interesting lines in the Business Roundtable statement was the assertion that “each of our individual companies serves its own corporate purpose,” because it acknowledges that the notion of purpose can’t be reduced to a single concept or metric.

Historically, the lines between industries were fairly clear-cut. Ford competed with GM and Chrysler. Later, foreign competition became more important, but the basic logic of the industry remained fairly stable: you produced cars and sold them to the public through a network of dealers.

Today, however, industry lines have blurred considerably. A company like Amazon competes with Walmart in retail, Microsoft, IBM and Google in cloud computing, and Netflix and Warner Media in entertainment. The company itself is much more than simply a bundle of operations competing in different value chains, but a platform for accessing a variety of ecosystems of talent, technology and information.

In much the same way, automobile manufacturers are making investments to transform themselves into mobility companies. To do so, they are building ecosystems made up of technology giants, startups and others. They are not seeking to “maximize bargaining power,” but rather to prepare for a future that hasn’t taken shape yet.

That’s why today, business leaders need to manage for mission, not for metrics. Building trustful relationships among a diverse set of stakeholders may not be as simple or as clear cut as “maximizing shareholder value,” but it’s increasing what profit-seeking businesses need to do to compete.

— Article courtesy of the Digital Tonto blog
— Image credit: Pixabay