Brain Drain

Emerging markets can win in the global war for talent by leveraging the talents of their expats.


"To study a banyan tree, you not only must know its main stem in its own soil, but also must trace the growth of its greatness in the further soil, for then you can know the true nature of its vitality".
—Rabindranath Tagore

Consider a few statistics. In the 1990s, roughly 650,000 people from emerging markets migrated to the United States on professional-employment visas. Over 40 percent of the foreign-born adults in the United States have at least some college education, thereby making that country the epicenter of the global talent drain (Exhibit 1). Foreign-born workers now make up 20 percent of all employees in the US information technology sector. About 30 percent of the 1998 graduating class of the famed Indian Institute of Technology—and a staggering 80 percent of the graduates in computer science—headed for graduate schools or jobs in the United States. Some 80 percent of foreign doctoral students in science and engineering plan to stay there after graduation—up from 50 percent in 1985 (Exhibit 2). Roughly a third of the R&D professionals of developing countries have left them to work in the United States, the members of the European
Union, or Japan.

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China and India: The race to growth Part - 3

Sector by sector

The strength of the Chinese and Indian economies will actually be decided at the industry level.

The answer to the question, "Which is the better approach to economic development?" is not to be found at the national level. You have to look at what's going on in individual industries. And when you do, you find that supportive government policies that encourage competition drive good performance. Both China and India have some sluggish, inefficient industries that are heavily regulated and lack competitive dynamism. But both countries also have successful industries that thrive unfettered by poor regulation.

The McKinsey Global Institute has long argued that the key to high economic growth is productivity and that the main barrier to productivity gains is the raft of microlevel government regulations that hinder competition. This idea is well illustrated in the case of India.

At the high end of India's productivity spectrum is the information technology, software, and business-process-outsourcing sector. It's a big success story, having created hundreds of thousands of jobs and billions of dollars' worth of exports. As a new sector—and one whose potential the government, in my view, failed to recognize early on—it has avoided stifling regulation. IT, software, and outsourcing companies are exempt from the labor regulations that govern working hours and overtime in other sectors, and they have been allowed to receive foreign direct investment, which is prohibited in retailing, for example. Without this foreign money, it is debatable whether the sector could have taken off. By 2002 it already accounted for 15 percent of all foreign direct investment in India.

In the middle of the spectrum is the auto industry, which has seen dramatic change since the government began to liberalize it in the 1980s. By 1992 most of the barriers to foreign investment had been lifted, and this made it possible for output and labor productivity to soar. Prices have fallen and, even as the industry has consolidated, employment levels have held steady thanks to robust demand. Nonetheless, with tariffs on finished cars still relatively high, automakers remain sheltered from global competition and the sector is less efficient than it could be.

At the low end of the spectrum is the consumer electronics sector, which, despite the lifting of foreign-investment restrictions in the early 1990s, is still burdened by tariffs, taxes, and regulations. As a result, Indian consumer electronics goods can't compete internationally and prices for local consumers are unnecessarily high. The performance of India's food-retailing industry is even worse. Partly as a result of a total ban on foreign investment, labor productivity is just 6 percent of US levels.

Now look at China, which also has some reasonably liberalized and highly competitive industries, including consumer electronics, in which labor productivity is double that of its Indian counterpart. Over the past 20 years, the industry has become globally competitive through a combination of foreign direct investment and intense competition among domestic companies. It is also remarkable for the relatively liberal approach the government has taken to regulation—probably because of a failure to see its growth potential. Today China makes $60 billion worth of consumer electronics goods a year.

The performance of China's auto industry—which was considered a strategic one and remains tightly regulated because of the government's desire to bring in technology and investment—is less clear-cut. The market has been opened up to foreign automakers, consumer demand has grown enormously, and prices have dropped. Yet the sector shows how government intervention can thwart the potential of foreign direct investment. Foreign automakers can invest only in joint ventures, they have to buy components from local suppliers, and tariffs shield the market from imports. Competition is beginning to increase as private companies grow stronger. But for the time being, the productivity of foreign joint ventures in China is low compared with that of plants in Japan or the United States—astounding given China's low labor costs.

Since there are such big differences in the performance of different sectors within the same country, it makes sense to compare the performance of India and China at the sector rather than the national level. In IT and business-process outsourcing, India is so far ahead of the game that China can't do anything during the next 10 or 15 years that would bring it close to catching up. In consumer electronics, however, China dominates, and India won't provide serious competition during the next 10 years.

The auto sector is a toss-up. India's competitive forces have driven an enormous amount of innovation in the sector. Low-cost labor has been used instead of expensive automation, and local engineering talent has developed innovative new products such as the Scorpio—a sport utility vehicle that sells for a fraction of the price of an equivalent car in the United States. In China, large amounts of foreign direct investment have built a big industry, but regulation has so far limited its competitive potential.

It is far from clear which economy will emerge as the stronger one. The foundations of robust, sustainable economic growth must be built at the industry level, on the back of high productivity, which is achieved when governments ensure a level playing field through sound regulation and remove the barriers that stifle competition. Both China and India still have ample opportunity to help their industries and economies thrive.

China and India: The race to growth Part - 2

China: The best of all possible models

In an efficient market, the private sector is better than governments at allocating investment funds. But China isn't an efficient market, and India has relatively little investment funding.
Finding fault with China's approach to economic development is easy: cyclical overcapacity, state-influenced resource allocation, and growing social inequalities are just a few of its shortcomings. But it's hard to see how any other model could have given the economy such a powerful kick start.

The Chinese government manages the development of enterprises with a view to driving economic growth. You can be a small entrepreneur in China, but if you want to be big you will have to get money from a government-affiliated source at some point. Government officials essentially have the power to decide which companies grow.

In achieving the objective of growth, this policy has been tremendously successful. China has quickly built industries large enough to drive its economy. Take the auto industry, now an important contributor to the manufacturing sector. Only 20 years ago, China had no auto industry to speak of; there were a few manufacturers of trucks but none of passenger cars. To get started, the government decided that in a high-scale, high-tech industry, some foreign company—in this case, Volkswagen—had to come in and show local ones what to do. Because most local companies were state-owned 20 years ago, Volkswagen was hooked up with a state-owned company.

You might argue that this development model has thwarted entrepreneurship. But there weren't any entrepreneurs in the industry at the time. There were no private companies that could partner with Volkswagen, let alone compete with it. The government simply said, "We want China to modernize. We want the Chinese economy to grow. We don't have the companies we need to make that happen, so we're prepared to do what it takes to create them."

The capital-intensive auto plants built with foreign partners in China as a result of its development policy may have no particular productivity advantage over the plants they might have built at home. But all of the spending by the big car companies has paid off.
Moreover, local, privately owned automakers such as Chery Automotive and Geely Automotive are beginning to thrive. A generation of entrepreneurs has put to good advantage the skills and training that the foreigners provided, so that Chinese companies now put together cars of reasonable quality much more cheaply than foreign automakers can. At present, domestic players benefit from the price umbrella that the foreign ones provide. But these smaller fry are now making cars for $2,000, which means that any company that has high cost structures will eventually suffer. With lower tariffs on the way because of China's accession to the World Trade Organization, and with new competitors proliferating, the automotive industry is heading into a classic price war that only the fittest will survive. This is precisely what happened in the consumer electronics industry, where competition led to the emergence of successful Chinese companies that operate globally. I think that in five or ten years' time, at least a third of the Chinese auto industry will be completely private—nothing to do with the current state players. And this will all have started with the state saying, "We want to build a car industry."

Looking at industry more broadly, inefficiencies and cyclicality have resulted from the fact that many funding decisions are driven at the local-government level. Local officials have GDP growth as a political-performance target, so many of them look for the biggest investments they can make to push along the regional economy. Like stock market investors pursuing the latest speculative fad, they have created a lemming effect, with lots of unsound investments, whether in aluminum smelters, residential real estate, or TV factories. The outcome tends to be waves of overcapacity as investments are made right up to—and sometimes way beyond—the point where it is patently obvious that the economics cannot justify them.

But remember that the essential mechanism of economic reform in China has been the encouragement of competition among provinces and municipalities. Until the 1980s there was no such thing in China as a national company. Everything was local. There was no single legal entity that operated more than five kilometers (about 3.1 miles) from its headquarters. With the removal of internal trade barriers, local entrepreneurs and their government backers invested to build scale and attack neighboring markets. Yes, this does lead to overcapacity and price wars. But over time—and relatively short periods of time, too—all that cyclicality also leads to shakeouts that the most competitive enterprises survive. These enterprises, thanks to their national scale and real competitive advantages, no longer depend on local-government funding and can now start to compete for the long term, both domestically and internationally.

That has certainly been the story in consumer electronics, where the top three players in personal computers control 50 percent of the domestic market, and in beer, where the top ten own 30 percent. It is starting to be the story in heavy industries, where companies such as China Qianjiang own 40 percent of the motorcycle market and Wanxiang dominates its niche in automotive components . Interestingly, it is not the foreign companies but the locals that tend to be the winners of the consolidation wars. The beer industry is a case in point: most foreign brewers, unprepared for tough domestic competition and rapid consolidation, entered and exited in the 1990s.

The government is fixing the banks through tough higher reserve margins, branch-level changes, and more flexible risk-based pricing

Moreover, I don't believe that foreign direct investment is linked to the development of China's capital markets or to a reform of the banking system. Multinationals account for only 15 percent of fixed-asset investment, so they don't drive the economy to a very great extent. China must rely on its own domestic financial resources to finance growth. As a result, the country's capital markets are being developed. And the government is fixing the banks through tough higher reserve margins, branch-level changes in performance management and incentives, and more flexible risk-based pricing.

As for the oft-stated view that China is trying to create global state-owned champions, it is at least partly a myth. The government does want to develop strong Chinese companies, but it does not expect them to be state enterprises, which are inefficient by definition. Indeed, it is now telling them that if they want to grow, they will have to get listed on the stock market. The government's policy for the first 20 years of its reform program was, "Let's do what's needed to establish markets." Its policy for the next 20 years will be, "Let's get out of those markets." The global Chinese companies of tomorrow will be competitive, mostly listed, and entirely commercial in their aims and purposes.

Ultimately, you have to ask whether the inefficiencies of the Chinese approach outweigh what it has achieved for the economy overall. The answer, I think, is no. The government still controls most of the country's financial resources and has been reasonably good at allocating them—that's why the economy has grown so fast. Compared with the private sector in an efficient market, the government is no doubt worse at allocating funds. But China is not an efficient market, and the Indian model—essentially one with relatively little investment funding, whether by the government or the private sector—could not have achieved as much growth for the Chinese economy as the approach China's government actually took. The Indian model might not be adequate for India's economy either: the country's family-owned businesses and other private investors may be good at deciding what makes a sound investment for them, but they have not spent enough money to drive the kind of growth seen in China. It would not surprise me at all to see investment in India rise dramatically as foreign and domestic investors alike begin to recognize its potential going forward.

China and India: The race to growth Part - 1

The world’s two biggest developing countries are taking different paths to economic prosperity. Which is the better one?

First it was China. The rest of the world looked on in disbelief, then awe, as the Chinese economy began to take off in the 1980s at what seemed like lightning speed and the country positioned itself as a global economic power. GDP growth, driven largely by manufacturing, rose to 9 percent in 2003 after reaching 8 percent in 2002. China used its vast reservoirs of domestic savings to build an impressive infrastructure and sucked in huge amounts of foreign money to build factories and to acquire the expertise it needed. In 2003 it received $53 billion in foreign direct investment, or 8.2 percent¹ of the world's total—more than any other country.

India began its economic transformation almost a decade after China did but has recently grabbed just as much attention, prompted largely by the number of jobs transferred to it from the West. At the same time, the country is rapidly creating world-class businesses in knowledge-based industries such as software, IT services, and pharmaceuticals. These companies, which emerged with little government assistance, have helped propel the economy: GDP growth stood at 8.3 percent in 2003, up from 4.3 percent in 2002. But India's level of foreign direct investment—$4.7 billion in 2003, up from $3 billion in 2002—is a fraction of China's.

Both countries still have serious problems: India has poor roads and insufficient water and electricity supplies, all of which could thwart its development; China has massive bad bank loans that will have to be accounted for. The contrasting ways in which China and India are developing, and the particular difficulties each still faces, prompt debate about whether one country has a better approach to economic development and will eventually emerge as the stronger.

India's entrepreneurial advantage

China has shackled its independent businesspeople. India has empowered them.

China and India have followed radically different approaches to economic development. China's resulted from a conscious decision; India more or less happened upon its course. Is one way better than the other? There is no gainsaying the fact that China's growth has rocketed ahead of India's, but the conventional view that the Chinese model is unambiguously the better of the two is wrong in many ways; each has its advantages. And it is far from clear which will deliver the more sustainable growth.

Together with Yasheng Huang, of the Sloan School of Management, at the Massachusetts Institute of Technology (MIT), I have argued that these approaches differ on two dimensions. First, the Chinese government nurtures and directs economic activity more than the Indian government does. It invests heavily in physical infrastructure and often decides which companies—not necessarily the best—receive government resources and listings on local stock markets. By contrast, since the mid-1980s the Indian government has become less and less interventionist. The second dimension is foreign direct investment. China has embraced it; India remains cautious.

These differences have an impact on the types of companies that succeed and, I would argue, on entrepreneurialism. Let's look first at what kinds of companies thrive. China trumps India when it comes to industries that rely on "hard" infrastructure (roads, ports, power) and will do so for the foreseeable future. But when it comes to "soft" infrastructure businesses—those in which intangible assets matter more—India tends to come out ahead, be it in software, biotechnology, or creative industries such as advertising.

Thus manufacturing companies whose just-in-time production processes rely on efficient road and transport networks fare poorly in India. But businesses that are unconstrained by shortages of generators and roads flourish. Soft assets underpin even the Indian car industry. Unlike China's car sector, which has expanded as a result of big capital investments from multinational companies, India's has succeeded on the back of clever designs that make it possible to produce cheap indigenous models. India actually sends China high-value-added mechanized and electronic components whose production depends more on know-how than on infrastructure.

Moreover, many hard-asset companies in China exist because the government funnels money to them. The government can do this because it intervenes in domestic capital markets. In India there is no such government intervention. Hence successful companies tend to cluster in industries where capital constraints are less of an issue. You don't need a deep reservoir of capital to start a software company; you do for a big steel plant.

The Indian government's lower level of intervention in capital markets and its decision not to regulate industries that lack tangible assets (software, biotech, media) have created room for entrepreneurs. Entrepreneurial activity is fueled both by incumbent (often family-owned) enterprises and by new entrants. The former use cash flows from diverse existing businesses to invest in newer ventures. In biotechnology, however, Biocon emerged from pure entrepreneurial effort, as did Infosys Technologies in software. Similarly, hundreds of smaller versions of companies such as Infosys and Wipro Technologies have no government links, unlike so many of China's successful companies.

Although India's stock and bond markets are hardly perfect, they do on the whole support private enterprise. Here too, entrepreneurialism has played a part, even improving India's institutional framework. Take the Bombay Stock Exchange (BSE), founded about 130 years ago and until recently the most inefficient entity imaginable. It has become radically more efficient in the past decade as a result of the competing efforts of an enterprising former bureaucrat named R. H. Patil. With technological inputs from around the world and some fancy footwork to dodge entrenched interests at the BSE, in 1994 he started a rival institution, the state-of-the-art National Stock Exchange of India, which now has more business. In China, by contrast, the government tries to make stock markets successful by command, with predictably little to show for its efforts. There has been little competition indeed between the Shanghai and Shenzhen exchanges.

Good hard infrastructure and the Chinese government's decision to welcome foreign investment make it reasonably easy for multinationals to do business in China, and since they bring their own capital and senior talent, they do not have to rely heavily on local institutions. China has no shortage of homegrown entrepreneurial talent. But indigenous companies have a much tougher time, hindered as they are by inefficient capital markets, a banking system notorious for bad loans, and the fact that local officials rather than market forces largely decide who receives funding.

The pros and cons of these two models should be studied, and it is fair to ask whether China's will hamper its economic development

China and India both have the ability to keep growing in their own very different ways for a decade or so. The Chinese government's intervention in the economy—including the decision to welcome foreign direct investment—has brought a material improvement in the standard of living that India hasn't enjoyed. It may also be that each country has chosen the path best suited to its own historical circumstances. But the pros and cons of these two development models should be studied, and it is fair to ask whether China's approach will hamper its future economic development.

Huang and I believe that the presence of so many self-reliant multi-national companies has partly relieved the Chinese government of pressure to develop or reform the institutions that support free enterprise and economic growth. And the fact that many domestic investments still are not allocated through sensible pricing mechanisms means that China wastes many of its resources. Productivity and long-term economic growth, as we all know, thrive on competition, which is all too often stifled by government intervention.

When the two countries are compared, it is easy to forget that India began its economic reforms more than a decade later than China did. As India opens up further to foreign direct investment, we might well discover that the country's more laissez-faire approach has nurtured the conditions that will enable free enterprise and economic growth to flourish more easily in the long run.

Nurturing entrepreneurship in India’s villages

The world’s great cities and the professionals who live in them are linked more tightly to one another than they are with their own rural hinterlands. Yet true prosperity starts in the countryside.

It’s not surprising that well-travelled professionals living in global cities, such as New Delhi, New York, Paris, Rio, and Shanghai, have more in common with one another, in lifestyle and values, than they do with rural citizens in their respective nations. In general, villagers, particularly in the emerging world, have benefitted less from globalization than urbanites have. Seventy percent of India’s citizens, for instance, live in rural isolation, largely disconnected from the benefits of their nation’s fast-paced economic growth.

These are globalization’s forgotten frontiers, where more must be done to connect urban markets with rural ones in order to speed their development. How this happens will vary from nation to nation. In China, for instance, the government actively spurred the village economy, largely through agricultural-reform measures implemented during the 1980s. By contrast, India’s government has only a limited ability to bring about real change in the country’s villages. Private entrepreneurs might well be more effective.

Recently, I trudged through the mire of a government-run food auction yard, or mandi, in Bangalore, the global economy’s offshoring capital. Piles of supposedly fresh produce lay everywhere, rotting in the sun and competing with mangy dogs and scampering mice for my attention. Huddles of impecunious farmers, wearing the traditional dhoti, looked on with resignation. A government agent, pen tucked behind ear, offered a pittance for the produce on display.

The farmers’ day had started before dawn. Chugging along on narrow so-called highways, they came to the auction yard in ramshackle public buses, bullock carts, trucks, and even tractors. Their produce unloaded, they accepted whatever they got. After snatching a few hours’ sleep in a shady corner, they retraced their steps home.

In India, agricultural mandates have long required farmers to sell their produce through such wholesale yards. Although meant to free poor farmers from the clutches of local moneylenders, the mandi has become a monopoly. The farmer remains exploited, but now by local political interests.

But let’s change the scene from a city market in India to a rural village in China. Not long after I visited Bangalore, I crisscrossed parts of Henan—the name means “south of the Yellow River” (Huanghe). The province, one of China’s most populous, is home to more than a hundred million people. I started in Zhengzhou, the capital, a major industrial center and railway junction, and traveled to Chengguan, a county seat with 100,000 inhabitants. Chengguan was scrupulously clean; municipal services were apparent even in the predawn hours. The city bustled, but there was no squalor in the streets. I then headed to the very small village of Qiu, with a population of no more than a few thousand. The paved roads, in better condition than the Massachusetts Turnpike and other highways I know at home, led right up to the cornfields on the edge of the village. Qiu itself, if not quite prosperous, had none of the desperation so obvious in many Indian villages.

Rural development is crucial for the overall development of a nation’s economy. China’s economic revolution started with the reform of its village enterprises; foreign direct investment followed. Agricultural development in rural areas generated economic surpluses that in turn fed light manufacturing in rural and semiurban areas and, ultimately, industrialization in urban ones. A virtuous cycle ensued. The economic surplus promoted reinvestment in new technology and released human capital for broader development. This was China’s path, as it was Indonesia’s, and Vietnam has taken it since 1989.

India, however, has not. The nation’s government has failed to invest in its villages. The farmers who sold their produce in a mandi in Bangalore live a daily struggle for existence in their home villages. Today, 89 percent of all rural households do not own a telephone, and 52 percent have no domestic power connection. The average village is two kilometers away from an all-weather road, and 20 percent of rural habitations must walk for miles to obtain safe drinking water, have access to it for only a few hours a day for much of the year, or have no access at all.

Where India’s government has failed, social and business entrepreneurs are accumulating a better track record. The Self-Employed Women’s Association (SEWA), for example, centered in Gujarat, has economically empowered hundreds of thousands of women, helping them to become economically self-sufficient by providing small loans to start myriad businesses catering to health care, elementary education, and the like. Companies such as Hindustan Unilever and Indian Tobacco Company (ITC) have long had distribution networks that provide some investment, goods, and services to Indian villages beyond the government’s reach.

India should take a page from China’s playbook and fix its villages, but not in the way China has. China’s strong government was able to force the rapid dissemination of rural agricultural reforms. India’s weak one cannot accomplish anything remotely comparable. Instead, India should seek to empower its villagers and nurture entrepreneurial activity, while also taking advantage of its strengths in the private sector. Corporations need a seat at the table of village reform—even multinationals, because the task of reform is so enormous. Outright foreign direct investment, by Düsseldorf-based Metro AG, for example, should be welcome, as should joint ventures, like the one between Bharti Enterprises and Wal-Mart Stores. Such businesses, together with local ones, can lay the foundations for a modern agricultural supply chain linking the village farmer with the urban market.

Only then will India, and not just its global cities, rise.

Hidden flaws in strategy

After nearly 40 years, the theory of business strategy is well developed and widely disseminated. Pioneering work by academics such as Michael E. Porter and Henry Mintzberg has established a rich literature on good strategy. Most senior executives have been trained in its principles, and large corporations have their own skilled strategy departments.

Yet the business world remains littered with examples of bad strategies. Why? What makes chief executives back them when so much know-how is available? Flawed analysis, excessive ambition, greed, and other corporate vices are possible causes, but this article doesn’t attempt to explore all of them. Rather, it looks at one contributing factor that affects every strategist: the human brain.

The brain is a wondrous organ. As scientists uncover more of its inner workings through brain-mapping techniques,¹ our understanding of its astonishing abilities increases. But the brain isn’t the rational calculating machine we sometimes imagine. Over the millennia of its evolution, it has developed shortcuts, simplifications, biases, and basic bad habits. Some of them may have helped early humans survive on the savannas of Africa ("if it looks like a wildebeest and everyone else is chasing it, it must be lunch"), but they create problems for us today. Equally, some of the brain’s flaws may result from education and socialization rather than nature. But whatever the root cause, the brain can be a deceptive guide for rational decision making.

The basic assumption of modern economics—rationality—does not stack up against the evidence

These implications of the brain’s inadequacies have been rigorously studied by social scientists and particularly by behavioral economists, who have found that the underlying assumption behind modern economics—human beings as purely rational economic decision makers—doesn’t stack up against the evidence. As most of the theory underpinning business strategy is derived from the rational world of microeconomics, all strategists should be interested in behavioral economics.

Insights from behavioral economics have been used to explain bad decision making in the business world,² and bad investment decision making in particular. Some private equity firms have successfully remodeled their investment processes to counteract the biases predicted by behavioral economics. Likewise, behavioral economics has been applied to personal finance,³ thereby providing an easier route to making money than any hot stock tip. However, the field hasn’t permeated the day-to-day world of strategy formulation.

This article aims to help rectify that omission by highlighting eight⁴ insights from behavioral economics that best explain some examples of bad strategy. Each insight illustrates a common flaw that can draw us to the wrong conclusions and increase the risk of betting on bad strategy. All the examples come from a field with which I am familiar—European financial services—but equally good ones could be culled from any industry.

Several examples come from the dot-com era, a particularly rich period for students of bad strategy. But don’t make the mistake of thinking that this was an era of unrepeatable strategic madness. Behavioral economics tells us that the mistakes made in the late 1990s were exactly the sorts of errors our brains are programmed to make—and will probably make again.

Flaw 1: Overconfidence

Our brains are programmed to make us feel overconfident. This can be a good thing; for instance, it requires great confidence to launch a new business. Only a few start-ups will become highly successful. The world would be duller and poorer if our brains didn’t inspire great confidence in our own abilities. But there is a downside when it comes to formulating and judging strategy.

The brain is particularly overconfident of its ability to make accurate estimates. Behavioral economists often illustrate this point with simple quizzes: guess the weight of a fully laden jumbo jet or the length of the River Nile, say. Participants are asked to offer not a precise figure but rather a range in which they feel 90 percent confidence—for example, the Nile is between 2,000 and 10,000 miles long. Time and again, participants walk into the same trap: rather than playing safe with a wide range, they give a narrow one and miss the right answer. (I scored 0 out of 15 on such a test, which was one of the triggers of my interest in this field!) Most of us are unwilling and, in fact, unable to reveal our ignorance by specifying a very wide range. Unlike John Maynard Keynes, most of us prefer being precisely wrong rather than vaguely right.

We also tend to be overconfident of our own abilities.⁵ This is a particular problem for strategies based on assessments of core capabilities. Almost all financial institutions, for instance, believe their brands to be of "above-average" value.

Related to overconfidence is the problem of overoptimism. Other than professional pessimists such as financial regulators, we all tend to be optimistic, and our forecasts tend toward the rosier end of the spectrum. The twin problems of overconfidence and overoptimism can have dangerous consequences when it comes to developing strategies, as most of them are based on estimates of what may happen—too often on unrealistically precise and overoptimistic estimates of uncertainties.

One leading investment bank sensibly tested its strategy against a pessimistic scenario—the market conditions of 1994, when a downturn lasted about nine months—and built in some extra downturn. But this wasn’t enough. The 1994 scenario looks rosy compared with current conditions, and the bank, along with its peers, is struggling to make dramatic cuts to its cost base. Other sectors, such as banking services for the affluent and on-line brokerages, are grappling with the same problem.

There are ways to counter the brain’s overconfidence:

1. Test strategies under a much wider range of scenarios. But don’t give managers a choice of three, as they are likely to play safe and pick the central one. For this reason, the pioneers of scenario planning at Royal Dutch/Shell always insisted on a final choice of two or four options.⁶
2. Add 20 to 25 percent more downside to the most pessimistic scenario.⁷ Given our optimism, the risk of getting pessimistic scenarios wrong is greater than that of getting the upside wrong. The Lloyd’s of London insurance market—which has learned these lessons the hard, expensive way—makes a point of testing the market’s solvency under a series of extreme disasters, such as two 747 aircraft colliding over central London. Testing the resilience of Lloyd’s to these conditions helped it build its reserves and reinsurance to cope with the September 11 disaster.
3. Build more flexibility and options into your strategy to allow the company to scale up or retrench as uncertainties are resolved. Be skeptical of strategies premised on certainty.

Flaw 2: Mental accounting

Richard Thaler, a pioneer of behavioral economics, coined the term "mental accounting," defined as "the inclination to categorize and treat money differently depending on where it comes from, where it is kept, and how it is spent."⁸ Gamblers who lose their winnings, for example, typically feel that they haven’t really lost anything, though they would have been richer had they stopped while they were ahead.

Mental accounting pervades the boardrooms of even the most conservative and otherwise rational corporations. Some examples of this flaw include the following:

• being less concerned with value for money on expenses booked against a restructuring charge than on those taken through the P&L
• imposing cost caps on a core business while spending freely on a start-up
• creating new categories of spending, such as "revenue-investment spend" or "strategic investment"

All are examples of spending that tends to be less scrutinized because of the way it is categorized, but all represent real costs.

These delusions can have serious strategic implications. Take cost caps. In some UK financial institutions during the dot-com era, core retail businesses faced stringent constraints on their ability to invest, however sound the proposal, while start-up Internet businesses spent with abandon. These banks have now written off much of their loss from dot-com investment and must reverse their underinvestment in core businesses.

Make sure that all investments are judged on consistent criteria, and be wary of spending that has been reclassified to make it acceptable

Avoiding mental accounting traps should be easier if you adhere to a basic rule: that every pound (or dollar or euro) is worth exactly that, whatever the category. In this way, you will make sure that all investments are judged on consistent criteria and be wary of spending that has been reclassified. Be particularly skeptical of any investment labeled "strategic."

Flaw 3: The status quo bias

In one classic experiment,⁹ students were asked how they would invest a hypothetical inheritance. Some received several million dollars in low-risk, low-return bonds and typically chose to leave most of the money alone. The rest received higher-risk securities—and also left most of the money alone. What determined the students’ allocation in this experiment was the initial allocation, not their risk preference. People would rather leave things as they are. One explanation for the status quo bias is aversion to loss—people are more concerned about the risk of loss than they are excited by the prospect of gain. The students’ fear of switching into securities that might end up losing value prevented them from making the rational choice: rebalancing their portfolios.

A similar bias, the endowment effect, gives people a strong desire to hang on to what they own; the very fact of owning something makes it more valuable to the owner. Richard Thaler tested this effect with coffee mugs imprinted with the Cornell University logo. Students given one of them wouldn’t part with it for less than $5.25, on average, but students without a mug wouldn’t pay more than $2.75 to acquire it. The gap implies an incremental value of $2.50 from owning the mug.

The status quo bias, the aversion to loss, and the endowment effect contribute to poor strategy decisions in several ways. First, they make CEOs reluctant to sell businesses. McKinsey research shows that divestments are a major potential source of value creation but a largely neglected one.¹⁰ CEOs are prone to ask, "What if we sell for too little—how stupid will we look when this turns out to be a great buy for the acquirer?" Yet successful turnarounds, such as the one at Bankers Trust in the 1980s, often require a determined break with the status quo and an extensive reshaping of the portfolio—in that case, selling all of the bank’s New York retail branches.

These phenomena also make it hard for companies to shift their asset allocations. Before the recent market downturn, the UK insurer Prudential decided that equities were overvalued and made the bold decision to rebalance its fund toward bonds. Many other UK life insurers, unwilling to break with the status quo, stuck with their high equity weightings and have suffered more severe reductions in their solvency ratios.

This isn’t to say that the status quo is always wrong. Many investment advisers would argue that the best long-term strategy is to buy and hold equities (and, behavioral economists would add, not to check their value for many years, to avoid feeling bad when prices fall). In financial services, too, caution and conservatism can be strategic assets. The challenge for strategists is to distinguish between a status quo option that is genuinely the right course and one that feels deceptively safe because of an innate bias.

To make this distinction, strategists should take two approaches:

1. Adopt a radical view of all portfolio decisions. View all businesses as "up for sale." Is the company the natural parent, capable of extracting the most value from a subsidiary? View divestment not as a failure but as a healthy renewal of the corporate portfolio.
2. Subject status quo options to a risk analysis as rigorous as change options receive. Most strategists are good at identifying the risks of new strategies but less good at seeing the risks of failing to change.

Flaw 4: Anchoring

One of the more peculiar wiring flaws in the brain is called anchoring. Present the brain with a number and then ask it to make an estimate of something completely unrelated, and it will anchor its estimate on that first number. The classic illustration is the Genghis Khan date test. Ask a group of people to write down the last three digits of their phone numbers, and then ask them to estimate the date of Genghis Khan’s death. Time and again, the results show a correlation between the two numbers; people assume that he lived in the first millennium, when in fact he lived from 1162 to 1227.

Anchoring can be a powerful tool for strategists. In negotiations, naming a high sale price for a business can help secure an attractive outcome for the seller, as the buyer’s offer will be anchored around that figure. Anchoring works well in advertising too. Most retail-fund managers advertise their funds on the basis of past performance. Repeated studies have failed to show any statistical correlation between good past performance and future performance. By citing the past-performance record, though, the manager anchors the notion of future top-quartile performance to it in the consumer’s mind.

Anchoring can be dangerous—particularly when it is a question of becoming anchored to the past

However, anchoring—particularly becoming anchored to the past—can be dangerous. Most of us have long believed that equities offer high real returns over the long term, an idea anchored in the experience of the past two decades. But in the 1960s and 1970s, UK equities achieved real annual returns of only 3.3 and 0.4 percent, respectively. Indeed, they achieved double-digit real annual returns during only 4 of the past 13 decades. Our expectations about equity returns have been seriously distorted by recent experience.

In the insurance industry, changes in interest rates have caused major problems due to anchoring. The United Kingdom’s Equitable Life Assurance Society assumed that high nominal interest rates would prevail for decades and sold guaranteed annuities accordingly. That assumption had severe financial consequences for the company and its policyholders. The banking industry may now be entering a period of much higher credit losses than it experienced during the past decade. Some banks may be caught out by the speed of change.

Besides remaining unswayed by the anchoring tactics of others, strategists should take a long historical perspective. Put trends in the context of the past 20 or 30 years, not the past 2 or 3; for certain economic indicators, such as equity returns or interest rates, use a very long time series of 50 or 75 years. Some commentators who spotted the dot-com bubble early did so by drawing comparisons with previous technology bubbles—for example, the uncannily close parallels between radio stocks in the 1920s and Internet stocks in the 1990s.

Flaw 5: The sunk-cost effect

A familiar problem with investments is called the sunk-cost effect, otherwise known as "throwing good money after bad." When large projects overrun their schedules and budgets, the original economic case no longer holds, but companies still keep investing to complete them.

Financial institutions often face this dilemma over large-scale IT projects. There are numerous examples, most of which remain private. One of the more public cases was the London Stock Exchange’s automated-settlement system, Taurus. It took the intervention of the Bank of England to force a cancellation, write off the expenses, and take control of building a replacement.

Executives making strategic-investment decisions can also fall into the sunk-cost trap. Certain European banks spent fortunes building up large equities businesses to compete with the global investment-banking firms. It then proved extraordinarily hard for some of these banks to face up to the strategic reality that they had no prospect of ever competing successfully against the likes of Goldman Sachs, Merrill Lynch, and Morgan Stanley in the equities business. Some banks in the United Kingdom took the agonizing decision to write off their investments; other European institutions are still caught in the trap.

Why is it so hard to avoid? One explanation is based on loss aversion: we would rather spend an additional $10 million completing an uneconomic $110 million project than write off $100 million. Another explanation relies on anchoring: once the brain has been anchored at $100 million, an additional $10 million doesn’t seem so bad.

What should strategists do to avoid the trap?

1. Apply the full rigor of investment analysis to incremental investments, looking only at incremental prospective costs and revenues. This is the textbook response to the sunk-cost fallacy, and it is right.
2. Be prepared to kill strategic experiments early. In an increasingly uncertain world, companies will often pursue several strategic options.¹¹ Successfully managing a portfolio of them entails jettisoning the losers. The more quickly you get out, the lower the sunk costs and the easier the exit.
3. Use "gated funding" for strategic investments, much as pharmaceutical companies do for drug development: release follow-on funding only once strategic experiments have met previously agreed targets.

Flaw 6: The herding instinct

The banking industry, like many others, shows a strong herding instinct. It tends to lend too much money to the same kinds of borrowers at the same time—to UK property developers in the 1970s, less-developed countries in the 1980s, and technology, media, and telecommunications companies more recently. And banks tend to pursue the same strategies, be it creating Internet banks with strange-sounding names during the dot-com boom or building integrated investment banks at the time of the "big bang," when the London stock market was liberalized.

This desire to conform to the behavior and opinions of others is a fundamental human trait and an accepted principle of psychology.¹² Warren Buffett put his finger on this flaw when he wrote, "Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press."¹³ For most CEOs, only one thing is worse than making a huge strategic mistake: being the only person in the industry to make it.

We all felt the tug of the herd during the dot-com era. It was lonely being a Luddite, arguing the case against setting up a stand-alone Internet bank or an on-line brokerage. At times of mass enthusiasm for a strategic trend, pressure to follow the herd rather than rely on one’s own information and analysis is almost irresistible. Yet the best strategies break away from the trend. Some actions may be necessary to match the competition—imagine a bank without ATMs or a good on-line banking offer. But these are not unique sources of strategic advantage, and finding such sources is what strategy is all about. "Me-too" strategies are often simply bad ones.¹⁴ Seeking out the new and the unusual should therefore be the strategist’s aim. Rather than copying what your most established competitors are doing, look to the periphery¹⁵ for innovative ideas, and look outside your own industry.

Initially, an innovative strategy might draw skepticism from industry experts. They may be right, but as long as you kill a failing strategy early, your losses will be limited, and when they are wrong, the rewards will be great.

Flaw 7: Misestimating future hedonic states

What does it mean, in plain English, to misestimate future hedonic states? Simply that people are bad at estimating how much pleasure or pain they will feel if their circumstances change dramatically. Social scientists have shown that when people undergo major changes in circumstances, their lives typically are neither as bad nor as good as they had expected—another case of how bad we are at estimating. People adjust surprisingly quickly, and their level of pleasure (hedonic state) ends up, broadly, where it was before.

This research strikes a chord with anyone who has studied compensation trends in the investment-banking industry. Ever-higher compensation during the 1990s led only to ever-higher expectations—not to a marked change in the general level of happiness on the Street. According to Tom Wolfe’s Sherman McCoy, in Bonfire of the Vanities, it was hard to make ends meet in New York on $1 million a year in 1987. Back then, that was shocking hubris from a (fictional) top bond salesman. By 2000, even adjusted for inflation, it would have seemed a perfectly reasonable lament from a relatively junior managing director.

Another illustration of our poor ability to judge future hedonic states in the business world is the way we deal with a loss of independence. More often than not, takeovers are seen as the corporate equivalent of death, to be avoided at all costs. Yet sometimes they are the right move. Two once great British banks—Midland and National Westminster—both struggled to maintain their independence. Midland gave in to HSBC’s advances in 1992; NatWest was taken over by the Royal Bank of Scotland in 2000. At both institutions, the consequences were positive for customers, shareholders, and most employees on any test of the "greatest good of the greatest number." The employees ended up being part of better-managed, stronger, more respected institutions. Morale at NatWest has gone up. Midland has achieved what was, for an independent bank, an unrealistic goal: to become part of a great global bank.

Often, top management is blamed for resisting any loss of independence. Certainly part of the problem is the desire of managements and boards to hang on to the status quo. That said, frontline staff members often resist a takeover or merger however much they are frustrated with the existing top management. Some deeper psychological factor appears to be at work. We do seem very bad at estimating how we would feel if our circumstances changed dramatically—changes in corporate control, like changes in our personal health or wealth.

How can the strategist avoid this pitfall?

1. In takeovers, adopt a dispassionate and unemotional view. Easier said than done—especially for a management team with years of committed service to an institution and a personal stake in the status quo. Nonexecutives, however, should find it easier to maintain a detached view.
2. Keep things in perspective. Don’t overreact to apparently deadly strategic threats or get too excited by good news. During the high and low points of the crisis at Lloyd’s of London in the mid-1990s, the chairman used to quote Field Marshall Slim—"In battle nothing is ever as good or as bad as the first reports of excited men would have it." This is a good guide for every strategist trying to navigate a crisis, with the inevitable swings in emotion and morale.

Flaw 8: False consensus

People tend to overestimate the extent to which others share their views, beliefs, and experiences—the false-consensus effect. Research shows many causes, including these:

• confirmation bias, the tendency to seek out opinions and facts that support our own beliefs and hypotheses
• selective recall, the habit of remembering only facts and experiences that reinforce our assumptions
• biased evaluation, the quick acceptance of evidence that supports our hypotheses, while contradictory evidence is subjected to rigorous evaluation and almost certain rejection; we often, for example, impute hostile motives to critics or question their competence
• groupthink,¹⁶ the pressure to agree with others in team-based cultures

Consider how many times you may have heard a CEO say something like, "the executive team is 100 percent behind the new strategy" (groupthink); "the chairman and the board are fully supportive and they all agree with our strategy" (false consensus); "I’ve heard only good things from dealers and customers about our new product range" (selective recall); "OK, so some analysts are still negative, but those ’teenage scribblers’ don’t understand our business—their latest reports were superficial and full of errors" (biased evaluation). This hypothetical CEO might be right but more likely is heading for trouble. The role of any strategic adviser should be to provide a counterbalance to this tendency toward false consensus. CEOs should welcome the challenge.

False consensus often leads strategists to overlook important threats to their companies and to persist with doomed strategies

False consensus, which ranks among the brain’s most pernicious flaws, can lead strategists to miss important threats to their companies and to persist with doomed strategies. But it can be extremely difficult to uncover—especially if those proposing a strategy are strong role models. We are easily influenced by dominant individuals and seek to emulate them. This can be a force for good if the role models are positive. But negative ones can prove an irresistible source of strategic error.

Many of the worst financial-services strategies can be attributed to over-dominant individuals. The failure of several Lloyd’s syndicates in the 1980s and 1990s was due to powerful underwriters who controlled their own agencies. And overdominant individuals are associated with several more recent insurance failures. In banking, one European institution struggled to impose effective risk disciplines because its seemingly most successful employees were, in the eyes of junior staff, cavalier in their approach to compliance. Their behavior set the tone and created a culture of noncompliance.

The dangers of false consensus can be minimized in several ways:

1. Create a culture of challenge. As part of the strategic debate, management teams should value open and constructive criticism. Criticizing a fellow director’s strategy should be seen as a helpful, not a hostile, act. CEOs and strategic advisers should understand criticisms of their strategies, seek contrary views on industry trends, and, if in doubt, take steps to assure themselves that opposing views have been well researched. They shouldn’t automatically ascribe to critics bad intentions or a lack of understanding.
2. Ensure that strong checks and balances control the dominant role models. A CEO should be particularly wary of dominant individuals who dismiss challenges to their own strategic proposals; the CEO should insist that these proposals undergo an independent review by respected experts. The board should be equally wary of a domineering CEO.
3. Don’t "lead the witness." Instead of asking for a validation of your strategy, ask for a detailed refutation. When setting up hypotheses at the start of a strategic analysis, impose contrarian hypotheses or require the team to set up equal and opposite hypotheses for each key analysis. Establish a "challenger team" to identify the flaws in the strategy being proposed by the strategy team.

An awareness of the brain’s flaws can help strategists steer around them. All strategists should understand the insights of behavioral economics just as much as they understand those of other fields of the "dismal science." Such an understanding won’t put an end to bad strategy; greed, arrogance, and sloppy analysis will continue to provide plenty of textbook cases of it. Understanding some of the flaws built into our thinking processes, however, may help reduce the chances of good executives backing bad strategies.

The demographic deficit: How aging will reduce global wealth

To fill the coming gap in global savings and financial wealth, households and governments will need to increase their savings rates and earn higher returns on the assets they already have.

The world's population is aging, and as it gets even grayer, bank balances will stop
growing and living standards, which have improved steadily since the industrial
revolution, could stagnate. The reason is that the populations of Japan, the United States,
and Western Europe, where the vast majority of the world's wealth is created and held,
are aging rapidly (Exhibit 1). During the next two decades, the median age in Italy will
rise to 51, from 42, and in Japan to 50, from 43. Since people save less after they retire
and younger generations in their prime earning years are less frugal than their elders
were, savings rates are set to fall dramatically.

Using branding to attract talent

To win the best recruits, a company must know how they perceive its brand.

Competition for talent is heating up in many industries and will probably intensify, since demographic trends make it increasingly difficult for companies to replace valued employees when they retire. In response, many companies are trying to sharpen the way they market themselves to recruits, by applying branding techniques to recruitment.

Our analysis indicates that few companies are as rigorous or precise at branding themselves as employers as they are at branding their products and services. Experience therefore suggests to us that many of these initiatives could fail. For a company to exploit its brand effectively when it fishes for talent, it must think of recruits as customers, use sophisticated marketing analysis to identify its key rivals, determine which corporate attributes matter most to specific types of recruits, and understand how best to reach them.

Surveys that rank favorite employers by industry are common; so too are surveys based on the recruits' academic focus, such as business, engineering, or science. But these surveys don't provide employers with the knowledge they really need: information on which companies are the most formidable competitors for the recruits they want and how to become more effective during the various stages of the recruitment process. Such areas of focus include increasing their name recognition among applicants to making potential recruits more familiar with what they do to persuading those recruits to consider them actively, apply for their jobs, and, finally, accept their offers