Luck plays a larger role than we think

From the excellent book of Nobel Price winner Daniel Kanehman Thinking, Fast and Slow, an excerpt on how we usually overestimate the role of CEOs and underestimate the role of luck in much of what happens in our lives. This excerpt is about CEOs and companies, but the book contains much more insights and observations about us that come from the work of Kanehman. This book is a must read.


Researchers measure the strength of relationships by a correlation coefficient, which varies between 0 and 1. The coefficient was defined earlier (in relation to regression to the mean) by the extent to which two measures are determined by shared factors. A very generous estimate of the correlation between the success of the firm and the quality of its CEO might be as high as .30, indicating 30% overlap. To appreciate the significance of this number, consider the following question:

Suppose you consider many pairs of firms. The two firms in each pair are generally similar, but the CEO of one of them is better than the other. How often will you find that the firm with the stronger CEO is the more successful of the two?

In a well-ordered and predictable world, the correlation would be perfect (1), and the stronger CEO would be found to lead the more successful firm in 100% of the pairs. If the relative success of similar firms was determined entirely by factors that the CEO does not control (call them luck, if you wish), you would find the more successful firm led by the weaker CEO 50% of the time. A correlation of .30 implies that you would find the stronger CEO leading the stronger firm in about 60% of the pairs—an improvement of a mere 10 percentage points over random guessing, hardly grist for the hero worship of CEOs we so often witness.

If you expected this value to be higher—and most of us do—then you should take that as an indication that you are prone to overestimate the predictability of the world you live in. Make no mistake: improving the odds of success from 1:1 to 3:2 is a very significant advantage, both at the racetrack and in business. From the perspective of most business writers, however, a CEO who has so little control over performance would not be particularly impressive even if her firm did well. It is difficult to imagine people lining up at airport bookstores to buy a book that enthusiastically describes the practices of business leaders who, on average, do somewhat better than chance. Consumers have a hunger for a clear message about the determinants of success and failure in business, and they need stories that offer a sense of understanding, however illusory.

In his penetrating book The Halo Effect, Philip Rosenzweig, a business school professor based in Switzerland, shows how the demand for illusory certainty is met in two popular genres of business writing: histories of the rise (usually) and fall (occasionally) of particular individuals and companies, and analyses of differences between successful and less successful firms. He concludes that stories of success and failure consistently exaggerate the impact of leadership style and management practices on firm outcomes, and thus their message is rarely useful.

To appreciate what is going on, imagine that business experts, such as other CEOs, are asked to comment on the reputation of the chief executive of a company. They poрare keenly aware of whether the company has recently been thriving or failing. As we saw earlier in the case of Google, this knowledge generates a halo. The CEO of a successful company is likely to be called flexible, methodical, and decisive. Imagine that a year has passed and things have gone sour. The same executive is now described as confused, rigid, and authoritarian. Both descriptions sound right at the time: it seems almost absurd to call a successful leader rigid and confused, or a struggling leader flexible and methodical.

Indeed, the halo effect is so powerful that you probably find yourself resisting the idea that the same person and the same behaviors appear methodical when things are going well and rigid when things are going poorly. Because of the halo effect, we get the causal relationship backward: we are prone to believe that the firm fails because its CEO is rigid, when the truth is that the CEO appears to be rigid because the firm is failing. This is how illusions of understanding are born.

The halo effect and outcome bias combine to explain the extraordinary appeal of books that seek to draw operational morals from systematic examination of successful businesses. One of the best-known examples of this genre is Jim Collins and Jerry I. Porras’s Built to Last. The book contains a thorough analysis of eighteen pairs of competing companies, in which one was more successful than the other. The data for these comparisons are ratings of various aspects of corporate culture, strategy, and management practices. “We believe every CEO, manager, and entrepreneur in the world should read this book,” the authors proclaim. “You can build a visionary company.”

The basic message of Built to Last and other similar books is that good managerial practices can be identified and that good practices will be rewarded by good results. Both messages are overstated. The comparison of firms that have been more or less successful is to a significant extent a comparison between firms that have been more or less lucky. Knowing the importance of luck, you should be particularly suspicious when highly consistent patterns emerge from the comparison of successful and less successful firms. In the presence of randomness, regular patterns can only be mirages.

Because luck plays a large role, the quality of leadership and management practices cannot be inferred reliably from observations of success. And even if you had perfect foreknowledge that a CEO has brilliant vision and extraordinary competence, you still would be unable to predict how the company will perform with much better accuracy than the flip of a coin. On average, the gap in corporate profitability and stock returns between the outstanding firms and the less successful firms studied in Built to Last shrank to almost nothing in the period following the study. The average profitability of the companies identified in the famous In Search of Excellence dropped sharply as well within a short time. A study of Fortune’s “Most Admired Companies” finds that over a twenty-year period, the firms with the worst ratings went on to earn much higher stock returns than the most admired firms.

You are probably tempted to think of causal explanations for these observations: perhaps the successful firms became complacent, the less successful firms tried harder. But this is the wrong way to think about what happened. The average gap must shrink, because the original gap was due in good part to luck, which contributed both to the success of the top firms and to the lagging performance of the rest. We have already encountered this statistical fact of life: regression to the mean.

Stories of how businesses rise and fall strike a chord with readers by offering what the human mind needs: a simple message of triumph and failure that identifies clear causes and ignores the determinative power of luck and the inevitability of regression. These stories induce and maintain an illusion of understanding, imparting lessons of little enduring value to readers who are all too eager to believe them.

Books on the world of Venture Capital

I have recently read two very good books on the world of Venture Capital that I would like to recommend:

this two books complement each other and give a great perspective on how the VC system works.

Smartphones war, Q4 2011 winners and losers

We have all the Q4 earnings reports, so with the results come some of the discussions on how the smartphones competition is evolving.

According to Horace Dediu, at Asymco Apple and Samsung captured about 90% of all available profits in the mobile phone industry. Then comes RIM third at 3.7%, HTC fourth at 3.0% and Nokia last at 1.8% of a $15 billion total for the quarter. See the post First: Apple’s rank in mobile phone profitability and revenues.

Furthermore, Q4 Y/Y growth of phone vendors:

  • Apple 128%,
  • Samsung 18%,
  • ZTE 17%,
  • HTC 10%,
  • RIM -1%,
  • Motorola -7%,
  • Nokia -8%,
  • Sony-Ericsson -20%,
  • LG -26%.

And the ratio R&D/sales shows that Apple spending at least 2 times less than its direct competitors, at 2.8%. See the post at Asymco, You cannot buy innovation:

Smartphones are experiencing  double digit growth, but a few are reaping all the profits with the rest lagging behind and even posting losses.

In terms of handset shipments, Nokia is still leading, according to Strategy Analyst, Nokia still top vendor as global handset shipments reached 1.6 billion in 2011:

In terms of smartphones platform market share, Canalysis reports some numbers, from the article Canalys: Apple led the way as smartphones overtook PCs:

For the year 2011, according to Canalys, the total smartphone shipments reached 488.0 million units, up 63% on the 299.7 million shipped in 2010. Apart from the numbers, it would be interesting to understand why so few winners and so many losers. Samsung smartphones use Android, Bada and Windows Phone, mainly Android though. And Apple uses its own iOS platform. Both the modular platform (Android) and the  vertical approach (Apple iOS) seem to be doing very well. And proprietary (relatively old) platforms  Symbian and BBOS (RIM) are suffering from the innovation of the newer platforms. But even vendors using Android are struggling to remain competitive and to differentiate even though the platform is experiencing an incredible growth. Then there is the Windows Phone OS, fighting for relevancy, now stuck at 1.4% market share in 2011. However, Nokia is now introducing several new handsets with this OS and the Nokia Lumia 900 has just won the best phone at CES , 2012 will be an important year for Microsoft and for Nokia. And while profitability has been greater in the smartphones segment, according to Tero Kuittinen Feature Phones Now More Profitable Than Mid-tier Smartphones. Android is growing but in Q4 has  lost market shares, mainly in North America, Tero Kuittinen Nielsen Numbers Bad Indeed for Android, RIM and if carriers sells more heavily subsidized iPhones they are in trouble too, as AT&T’s profitability deteriorated as more than 80% of its smartphone activations were now taken over by the heavily subsidized iPhone, see Tero Kuittinen Android Share Dive Aftershocks.

We have seen a lot of data but a lot of questions remain:

  • What should smartphones vendors do to remain relevant? Create their own platform? Use a modular or a proprietary vertical oriented approach?
  • Even though this is a battle of ecosystems, not all the players in the ecosystem are successful, actually only a few of them are able to compete