The Toothbrush Test
Friday, September 25, 2015
Almost 80% of us believe that we are above-average drivers, a statistical impossibility. This overconfidence in one’s ability is a common bias in the business world too. Ego and overconfidence often drive CEOs to believe in unrealistic outcomes, particularly when it comes to mergers and acquisitions.
It has been 15 years since the deal between AOL and Time Warner, often referred to as the worst merger of all time. Shortly after the deal closed, the dot-com bubble burst, advertising spending dried up and the economy entered a recession. This is a prime example of overly optimistic managers overreaching with shareholder money. So how do effective managers avoid the overconfidence effect?
Google CEO Larry Page has a simple solution to reduce potential acquisition mistakes. His “toothbrush test” asks if a prospective acquisition is something you would use daily and if it makes your life better. Rather than using elaborate formulas and projections, which are prone to error, Page’s approach is simple and guided by common sense and long-term thinking.
Last year, Google acquired Nest, a home automation company. Nest uses machine learning in their products, including smart thermostats, smoke detectors and Wi-Fi cameras, to improve their functionality and convenience. Nest’s market potential is huge but more importantly, its products help people save money and conserve energy.
While it is impossible to completely avoid or eliminate mistakes, we, as investors, can keep our biases in check and simplify our approach. In general, when it comes to acquisitive companies, we prefer managers who hold a meaningful amount of their own stock. With aligned interests and skin in the game, decisions tend to be made by reason, not ego.
Through better understanding of fundamental psychology and behavioural motivation, we can reduce errors and improve our performance. And, of course, we should always remember to brush our teeth.
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