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The Math of Low Trust

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Trust in business has declined in recent years. One reason why can be demonstrated with a bit of math.

Assume two streams of income, with a net present value calculation for each. (I’ll use a 10% discount rate to simplify). Income stream A has a big payment in year 2 and then pays slightly more per year – but only for 5 years, after which it all ends.

Income stream B is steady and solid, giving less income per year – but lasting 8 years.

NPV Chart

Which income stream do you choose? If you’re a dutiful MBA or financial manager, then in theory you choose B, the one with the higher NPV. In fact, in the real world, stream A is chosen far more often – for two reasons.

Reason 1. What if the example were ended after 7 years, instead of 8 years? In that case, the NPV of Income Stream B would drop to $44.72 – so presumably you’d choose Stream A, which is  unchanged at $46.17.

Timeframe makes a difference. If the average time you spend in a job is less than 8 years, and you are a rational self-maximizing business person, you’ll choose a far shorter timeframe in which to maximize your performance, because that’s what you can control. And these days, it’s more like 2 years than 8.

Reason 2. In the above example, the unspoken assumption is that it is, in fact, a solitary single example. But assume there are thousands of investment opportunities out there, with very similar payoff characteristics. In which case the smart thing would be to take Income Stream A – and then sell it after two years.  Then go find a new Income Stream A in which to invest your profits, and do it all over again. That way you’ll vastly out-perform either strategy, in virtually any time frame.

Or – would you?

Trust and Net Present Value

What’s this got to do with trust? Think back to Walter Mischel’s famed marshmallow study on deferred gratification. We do not trust people who have no self-will, who cannot defer their desire for instant gratification, because they are not in charge of their own desires. But that’s just one marshmallow incident; the rationale doesn’t go beyond Reason 1 above. What happens when one’s choices can be made over and over again?

That pattern – endlessly taking short-term gratification and jumping off onto a new high-then-low curve – is a very familiar one. It is what characterizes alcoholism, addiction, and it explains why junk food sells. “Just one more drink; one more cigarette; one more Frito. I’ll quit tomorrow, honest.”  But there’s always another drink at hand, and cigarettes and Fritos are ubiquitous.

The connection to business? Easy. Think about the obsession with quarterly earnings. Think about Wall Street’s “IBGYBG” mantra (I’ll be gone, you’ll be gone – do the deal). Think sales quotas, weekly P&Ls, constantly refreshing online metrics for performance. A myriad of new front-end loaded opportunities for instant gratification. Running a business this way perverts strategy in favor of a series of opportunistic NPV calculations.

Business Since 1970 – One Major Trend

Biggest trend of the last 40 years?  An obsession with markets. We have pursued, especially in finance, the grail of frictionless markets, believing that the Invisible Hand will save us by converting our individual selfishness into collective good.

It’s a crock. What markets have also done is encourage NPV calculations everywhere, all the time, and everything is monetized so we can compare them. There’s always another front-end loaded curve to buy into. Buy it and flip it. Invent a new business and IPO it before it goes profitable. IBGYBG. Markets – abetted by modularization and outsourcing and communications – have enabled massive short-termism in business.

The game works until the game doesn’t work. It works if you assume your grandchildren’s world will not suffer by your focus on short-term NPV enhancement. It works if you assume that a culture of instant monetization will beat Chinese strategies from a civilization accustomed to thinking in centuries.  It works if you assume that long-term good is achieved by means of constant short-term optimization.  But it isn’t.

Trust and Short-Termism

There’s  a reason that one the Four Trust Principles is “Focus on the medium-to-long term, not the short term; develop relationships, not transactions.” It’s because trust is born from long-term commitments; the confidence that the other party is after something besides their own instant gratification. Short-termism is perhaps the most perniciously anti-trust business phenomenon of our times. We have been poisoning our corporate cultures through a relentless focus on markets, monetization, analytics and processes.

Those are not the basis of trust. A commitment to long-term principles and relationships is the basis of trust.

The ROI of Business Friendships

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Karen Salmansohn publishes a “Be Happy Dammit Tips” Newsletter. She quotes some fascinating statistics about the value of business friendships. For example:

– People with a best friend at work are seven times more likely to be engaged in their work.

– Close friendships at work boost employee satisfaction by nearly 50%.

– People with at least three close friends at work are 46% more likely to be extremely satisfied their job – and 88% more likely to be satisfied with their lives.

– Employees who are good friends with their bosses are more than twice as likely to be happy with their work.

The relevance of friendship is not new to the world of professional services. David Maister writes about friendship in his article titled Young Professionals: Cultivate the Habits of Friendship . He asserts, “The way most clients choose among professionals is essentially identical to the way people choose their friends. At the point of selecting a professional to work with, clients go with providers who can:

(a) make them feel at ease;

(b) make them feel comfortable sharing their fears and concerns;

(c) can be trusted to look after them as well as their transaction and (d) are dependably on their side.”

It seems logical to infer that clients who view you, their business advisor, as a friend are at least doubly more likely to be engaged in the work you do and be satisfied with the results you produce.

Take stock: how many clients can you call “friend”?

Short-termism, ROI and Green Economics

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From BusinessWeek comes the painful story of an idealist butting heads with resistance and inertia. Nominally it’s a story of Green economics — identifying ways to be profitable while reducing environmental impact.

But it’s also about an emphasis on short-term economics that is not only paralyzing environmental activity, but is harming business and society.

Think of it as the triumph of payback time over ROI analysis.

Auden Schendler is a classic young outdoorsman environmentalist, full of hope that his employer, Aspen Skiing Company, will “get it” regarding his recommendations.

He recommended a $100K project to remodel the oldest lodge; it has a 7-year payback.

Too long, said the company.

OK, then, how about fluorescents in guest rooms—a 2-year payback in eco-friendly savings.

Nope, not warm enough light for guests.

OK then, how about $20K to save $10K per year in the underground garage?

No, we’d rather spend it on amenities guests notice.

It took Schendler two years to overcome resistance to the garage-light replacement, and then only after he secured a $5,000 grant from a local nonprofit. He acknowledges the strangeness of a corporation with annual revenue of about $200 million, according to industry veterans (the company declines to provide a figure), seeking charity to reduce its electricity use. With a hint of sarcasm, he notes: "This is the sort of radical action that’s needed to get people over ROI thresholds."

BW is writing about Green economics. But look at the examples.

What kind of capitalistic enterprise is passing up 50% returns on investment? The answer—a whole lot of them.

Our economy is increasingly governed by the belief that a bird in the hand is worth more than two in the bush—because that two-bird bush could blow up at any time, and besides, you just might find a four-bird bush around the corner.

Look at the forces of short-termism at work:

• The average length of ownership of a stock is down by orders of magnitude from a decade ago;
• mortgages used to be resold once or twice; now they are sliced and diced and repackaged into securities that are themselves sold over and over;
• the growth of private equity is, among other things, a shortening of the time period of evaluating a company’s worth;
• the growth in auto leasing represents a shortened ownership period;
• Real estate is increasingly a short-term investment to be “flipped;”
• Outsourcing reduces the time required to make a switch in organizations;
• Divorce rates, clothing style cycle times and TV show lifespans—all becoming shorter.

A shift toward transactions goes hand in hand with a reduced time perspective. These shifts make for more efficient markets, and reduce transactional costs (though increasing their number). But there’s a big downside: if everyone’s looking for fast hits, then no one’s around to play the long game.

Mathematically, there are three reasons payback analysis is supplanting ROI analysis:

1. Investment “owners” are turning over faster; I want mine now, thank you;
2. Uncertainty feeds the “get rich quick” mentality; why tie your money up because,hey, you never know!
3. Uncertainty also feeds perceived risk. In effect, investments are being assessed at increasing hurdle rates for farther-out timeframes (note to self—or kind reader?—check bond markets for evidence of this)

So we get more of this kind of thinking:

• Why should a private equity firm invest in anything beyond what will increase the return when the company is sold in three years?
• Why should any company invest with a longer timeframe than three years, lest it be taken over by a private equity firm?
• Why should a company invest in employees, since after all they might leave?
• Why should a company invest in customers if the payback takes over a few years?
• Why invest in branding? In training? In anything you can outsource? (And make sure the outsource contract shows a payback of at least two years).

With this kind of thinking endemic, it’s no wonder we’ve got a hard time figuring out how to reform social security, save the environment, deal with immigration, or rebuild falling bridges. It’s just not fast enough to suit us.

Thank goodness Schendler has the optimism of youth. He doesn’t know what he’s up against.