How You Can Outsmart Multi-Million Dollar Computer Models With Common Sense

by Dov Gordon

The Wall Street Journal recently ran an article about how insurance giant AIG relied on a faulty computer model and lost tens of billions of dollars. (How faulty computer models left giant AIG near collapse, 2008-11-3)

AIG began selling credit-default swaps in 1998 based on customized models designed by Professor Gary Gorton. According to a Journal source, Gorton’s work helped convince Mr. Joseph Cassano, head of the Financial Products unit at the time, that “…these things were only gold, [that] if anybody paid you to take on these risks, it was free money because AIG would never have to make payments to cover actual defaults…”

Well, sometimes lead shines like gold. How can you and I avoid being tempted by illusion?

Timeless principles and common sense

It is easy to see lead where others see gold – and gold where others see lead – if you allow yourself to be guided by timeless principles and common sense.

There are all kinds of psychological tricks our brains play on us, tempting us to follow a seemingly endless variety of logical fallacies, cognitive biases and just plain temptation. A short list, evident in the AIG story, would include our tendency towards over-optimism, the herding instinct and ignorance of risk. A longer risk can be found here.

So we make all kinds of poor decisions that we could have avoided had we only stopped to think: “What would common sense say about this?”

Your marketing isn’t gaining traction? Principles and common sense dictate that people will do what they perceive to be in their own best interest. If your marketing program is driven by what is expedient or technologically hip rather than what your market really cares about – well, it won’t work.

Another example: Success tends to make us comfortable and cocky, when it should make us humble and bring a dose of paranoia. The result? Success is a leading cause of failure.

The AIG example: You don’t get something for nothing; anything worthwhile comes at a price. So when a multi-million dollar computer model points to an opportunity that is “…only gold… [and] free money…” you should quickly run away. Clearly the system is too complex for accurate modeling - as was the case with AIG.

If not geeks bearing formulas, then what?

It is safe to assume that the executives at AIG were intelligent. If intelligence isn’t enough protection from cognitive biases and self-deception, how can you protect yourself and your business?

The answer: simple disciplines and practices.

To ensure that your marketing programs will really draw in new business, develop practices of listening to what your market is really saying – not what you wish they were saying. One woman I read about recently has been setting up two chairs in the lobby and just listening. There is often a line of people waiting to talk and share.

After a big success, institute some practices that will temper feelings of over-confidence and any tendency towards complacency. One idea might be to hold a series of discussions aimed at airing a more paranoid perspective.

To ensure that you are not ignoring obvious risks in a deal or strategy, (those opportunities that “can be only gold”) promote open debate amongst your employees and really listen to what people say – especially if it isn’t what you want to hear. (“Interesting that you see it that way because that wasn’t how I saw it. Please tell me more about why you see it the way you do.”) Make this an organizational practice and reward people for both soliciting dissension and for dissenting.

Warren Buffett: Disciplined thinking, disciplined action, enviable results

It’s your job (and mine) to identify the cognitive biases most likely to snag you and set up protective disciplines and practices.

Buffett’s investment philosophies and approaches are legendary. Yet how many people really take to heart the simple insights he has to offer? His real lessons for us are to see things as they are and not as we wish them to be.

As the markets rose, Buffett waited patiently, unwilling to invest just because he had billions in cash burning a hole in his pocket. When they crashed, he was well positioned to take advantage with his high profile preferred investments of $5 billion in Goldman Sachs and $3 billion in GE.

Professor Gorton, the architect of AIG’s disastrous model, recently lamented “how the financial markets came unglued after a series of unexpected events.”

Unexpected events?! We can’t predict future events, nor do we need to.

When your business and life decisions are guided by a wish to take advantage of others, to get something for nothing or for a quick win without really adding value, you had better be very careful: sooner or later you’ll be dragged through the mud by an unexpected event.

When your business and life decisions are guided by principles, disciplines and timeless wisdom, unexpected events will rarely catch you off guard.

Copyright 2008 © by Dov Gordon. All rights reserved.

DOV GORDON helps senior executives transcend the challenges, and leverage the opportunities, caused by growth and success. He is sought after for his perspective and advice on formulating and implementing strategy, developing strong management at all levels and cultivating innovation. Dov can be reached via his websites www.GordonGroupEC.com and www.Superior-Strategy.com or via email to dovgordon@gmail.com

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