Some of the most interesting things I've read in the last year are books like Daniel Gilbert's Stumbling on Happiness and Eliezer Yudkowsky's work on cognitive biases and risks [pdf], which take a close look at the psychological limitations of thinking about the future. Of course, the claim that futurists– or OR people, accountants, etc.– make is that the tools they use can correct for these biases.
But a Wharton accounting professor's recent studies suggest that even the apparently most rigorous quantitative tools can contribute to our holding faulty views of the future:
Accounting techniques like budgeting, sales projections and financial reporting are supposed to help prevent business failures by giving managers realistic plans to guide their actions and feedback on their progress. In other words, they are supposed to leaven entrepreneurial optimism with green-eye-shaded realism.
At least that's the theory. But when Gavin Cassar, a Wharton accounting professor, tested this idea, he found something troubling: Some accounting tools not only fail to help businesspeople, but may actually lead them astray. In one of his recent studies, forthcoming in Contemporary Accounting Research, Cassar showed that budgeting didn't help a group of Australian firms accurately forecast their revenues. In a second paper,he found that the preparation of financial projections added to aspiring entrepreneurs' optimism, leading them to overestimate their subsequent levels of sales and employment.
"It's been shown in many studies that people are overly optimistic," Cassar says. "What's interesting here is that, when you use the accounting tools, the optimism is even more extreme. This suggests that using the tools, which a lot of academics and government agencies say is good practice, can lead to even bigger mistakes."
The second of the two studies is more interesting here, because it asks whether doing things like writing business plans and creating sales projections make entrepreneurs more realistic or less realistic in their views of the future. He draws on the work of behavioral economists, who
have documented a number of mental shortcuts and biases that can lead people to depart from the logic that traditional economic orthodoxy would suggest. One of the concepts, for example, introduced by Nobel Laureate Daniel Kahneman and co-author Dan Lovallo, is that "an inside view" can distort decision making. A person who adopts an inside view becomes so focused on formulating his particular plan that he neglects to consider critical outside information, like other people's experiences in pursuing the same goal.
"Individuals form an inside view forecast by focusing on the specifics of the case, the details of the plan that exists and obstacles to its completion, and by constructing scenarios of future progress," Cassar summarizes. "In contrast, an outside view is statistical and comparative in nature and does not involve any attempt to divine the future at any level of detail."
Doing financial projections for an entrepreneurial venture, Cassar realized, entails the creation of an inside view. The entrepreneur builds a storyline of success in her head and then plays it out in her spreadsheet, showing rising sales year after year. "Humans are good at storytelling and building causal links," Cassar notes. "They think, 'I'll go to college, I'll write a business plan, I'll raise some capital and then I'll go public or sell out to a big competitor.' There's a probability attached to each of these steps, but they don't think about that. They put all the links together and evaluate the likelihood of success at a much higher probability than is realistic."…
People who did financial projections were the most likely to overestimate the future sales of their ventures. In other words, "the same management activities that entrepreneurs rely on to cope with uncertainty appear to be causing individuals to hold optimistic expectations," he writes. Interestingly, writing a business plan also led to optimism about the likelihood of success, but it didn't lead to overly optimistic expectations because it's also "positively associated with the likelihood that the nascent activity will become an operating venture," he adds. Put another way, people who write plans are more likely to start companies, thereby justifying their optimism.
The details are worth looking at, but the basic moral is clear: what seem like rigorous tools can lead people astray, through a combination of their apparent rigor, and the ways their use generates inside views. The interaction of users and tools co-produces what looks like objective data, and a particular way of looking at that data that's likely to exaggerate the odds of success and downplay the odds of failure.
Now for entrepreneurs you can argue that this is a good thing, and that entrepreneurs aren't successful if they dwell too much on the risks of failure. Starting your own company is an exercise is controlled, disciplined self-delusion. But how much do these kinds of biases– ones generated by a combination of apparently good information and processes that generate inside views– affect the work of futurists? I wonder.