Wikipedia defines this as, ”the principal-agent problem or agency dilemma treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent.”

From the Invetopedia: 

Principal-Agent diagram from Wikipedia

This diagram displays a simple representation of the agency problem.  The principal hires the agent to provide effort.  The principal and agent have divergent self interests which lead to differing motivating factors.  This leads the principal to create incentives to help align the agent’s interests with their own.  I’d add a second loop from the Principal to the Agent to signify monitoring which takes the place of hiring ex post.

More to come on this topic…

Author: Charles Roxburgh

Article detailing eight common flaws of the human brain as theorized by behavioral economists.

Flaw 1: Overconfidence

• Key ingredient in generating start-ups even though few are successful. (Good for the overall economy.)
• Acutely noticed in our efforts to make accurate estimates, assessments in our own abilities and optimism about potential outcomes

Flaw 2: Mental Accounting

• Definition: The inclination to categorixe and treat money differently depending on where it comes from, where it is kept, and how it is spent.  (i.e. Gamblers giving back winnings and calling it “house money”.

Keys to avoinding mental accounting:

1. All spending should be judged on consistent criteria
2. Be aware of spending that has been reclassified (i.e Moving to a bucket where it won’t be as noticeable.)

Flaw 3: The status quo bias

• Fear of change/People prefer to leave things as they are
• “McKinsey research shows that divestments are a major potential source of value creation, but a largely negelected one.”
• CEOs fear that they will sell for too little or that divested properties will take off making them look foolish

Avoiding status quo bias:

1. View all businesses as up for sale and determine whether you are the best parent for them
2. View divestiture not as failure, but healthy renewal and as opportunity to concentrate on core businesses
3. Subject status quo options to the same rigorous analysis as change options

Flaw 4: Anchoring

• Standard negotiation tool of setting a post out on the fringe making the counterparty more likely to work toward that number
• Anchoring on past performance is dangerous (i.e. Past perfomance is not an indication of future results…)

Dealing with anchoring:

1. Be prepared for it in negotiation and possibly use it to your advantage
2. Compare past performance over long time horizons to avoid getting caught up in unsustainable short term gains

Flaw 5:  The sunk-cost effect

• “Throwing good money after bad.”  
• Continuing a losing project due to the amount of capital already invested, which should be deemed irrelevant.
• Ex.  Choosing to spend an add’l $10M to complete a failed $100M project as it is just another $10M and at least we’ll get something out of it…

How to avoid this trap:

1. Apply the full rigor of analysis to incremental investments
2. Be prepared to kill strategic experiments early 
3. Use “gated funding” rather than releasing all funding at the outset of a project

Flaw 6:  The herding instinct

• Decision convergence
• Warren Buffett quote: “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.” (i.e. “Nobody ever got fired for hiring IBM.)
• Innovative strategies are likely to draw criticism initially

Avoiding the herding instinct:

1. Think for yourself
2. Kill failed strategies early to limit losses and afford opportunities to try again

Flaw 7: Misestimating future hedonistic states

• “People are bad at estimating how much pleasure or pain they will feel if their circumstances change dramatically.”   “People adjust surprisingly quickly and their level of pleasure (hedonistic state) ends up, broadly, where it was before.”
• Nothing here about the potential statehood for any small island nations…

How to avoid this misestimating future hedonistic states:

1. In takeovers, remain dispassionate and unemational.
2. Don’ overreact to news.  ”In battle nothing is ever as good or as bad as the first reports of excited men would have it.” -Field Marshall Slim

Flaw 8: False consensus

• Confirmation Bias – Seeking out the opinions and facts that support your cause
• Selective Recall – Remembering only the facts and assumptions that support our own beliefs and hypotheses
• Biased Evaluation – Quick acceptance of supportive evidence and rigorous evaluation, refutation and almost certain rejection of contradictory evidence
• Groupthink – The pressure to agree in team based settings (Team based stupidity)

How to avoid false consensus:

1. Create a culture of challenge (Pass on the yes men.)
2. Use checks and balances control dominant players
3. Avoing “leading the witness.”  Ask for refutations rather than validation of your ideas. (Find a devil’s advocate)

Author: Hugh G. Courtney

Brief McKinsey article espousing the benefits of Game Theory for strategic planning.  

The five key elements of competitive intelligence:

1. Define the strategic issue – What decision (set of decisions) are you attempting to make?  
2. Determine the relevant players – Who are the relevant actors who will be interested in. affected by, or affecting your decisions?
3. Identify each players stragic objective – Are they likely to pursue rational-profit maximizing objectives, or are they tied to short term measures which will force them to behave in unexpected ways?
4. Identify the potential actions for each player – What are the options of each of the players?  Each player is likely to have a different set of choices available to them due to their differing situations.
5. Determine the likely structure of the game – How will the game play out?  Will a first mover likely gain share, or will followers gain from their learnings?  Is this a one-time decision(possibly entry or exit) or a repetitive game (possibly pricing)?  

Key learnings:

• Aforementioned framework for utilizing game theory in strategic planning
• Boiling down a scenario to its basic elements affords the opportunity to utilize game theory without creating an overly complicated simulation
• Game Theory exercises can often create awareness of incentives and likely moves of other players even when used with incomplete information
• Modeling can help managers to realize the need to change the game enhancing the opportunity to create value and decrease incentives for destructive competition

It then differentiates Strategy from “tactics, or immediate actions, with resources at hand by its nature of being extensively premeditated, and often practically rehearsed.”  -Starting to get a little scary here, we’ll move on quickly…

Word Origin: The word derives from the Greek word stratēgos, which derives from two words: stratos (army) and ago (ancient Greek for leading). Stratēgos referred to a ‘military commander’ during the age of Athenian Democracy.  - Hence my love, as a child,  for the game Stratego.