The Foundation of Investment Decisions

Strategic decisions are never simple.  Despite the significant resources investment managers devote to the decision process, they often make judgments that go wrong because of human shortcomings.  Behavioral economics teaches that human biases, such as over-optimism about the likelihood of success, often affect the decision process, and employee incentives may be misaligned with long-term investment results.  

Most investment managers know about these pitfalls.  Yet cognitive bias distorts the way managers collect and process information, and judgment often is colored by self-interest.  Overoptimism and loss aversion (the human tendency to experience loss more acutely than gain) are the causes. All investment decisions have two essential components: the likelihood of the expected outcome, and the value placed on it.  When investment probabilities are based on repeated events optimism may be less of a factor. 

The Impact of Loss Aversion

But loss aversion also influences investment decisions.  Consider Boeing’s design and marketing decisions for the 737MAX.  Did Boeing sacrifice safety and airframe design principles to meet competitive pressures from the Airbus A320neo?  Boeing and Airbus operate a ‘duopoly’ in the market for single-aisle jets (valued at over $3.5 trillion over the next 20 years).  Neither can afford to fall behind.  Boeing had considered the single-aisle market large enough to launch a new aircraft design (New Midsize Airplane, “NMA”).  But in 2011, when American Airlines announced a record order for 460 single-aisle planes from Airbus (260 A320, 130 of which were the A320neo) and 200 737s from Boeing, Airbus had managed to break the longstanding monopoly Boeing had with American.  

The Airbus order, “loss aversion’ and market forces forced Boeing to commit to revamp its best-selling 737 with new engines rather than develop an all-new NMA.  Analysts had said that developing an all-new replacement for the 737 would have cost Boeing as much as $12 Billion. But with the 737MAX grounded world-wide since March 2019, Boeing has now booked $9.2 billion in charges.  In the rush to meet market competition Boeing opted not to develop the new jet.  Now, Boeing may still be required by regulators to re-approve the plane as a separate aircraft type from the 737 family.

Mitigating Risk

As investment decisions are evaluated, a misalignment of time horizons frequently leads to the wrong decisions.  Short term paybacks are favored over the impact decisions may have on longer investment horizons. Precision scheduled railroading (“PSR”) promises to improve operating ratios, train speeds, and yard through-put.  But the Rail Industry is not addressing how to provide delivery precision to the final railway freight shippers’ docks.  Boeing’s re-engined 737 and the Class One’s PSR implementation are examples of optimizing short-term performance at the expense of customer relationships and longer-term corporate health.  Boeing feared the loss of market share and Class One’s fear of being left behind. This ‘loss aversion’ phenomenon can lead decision-makers astray. 

Be reluctant to ‘bet the farm’ on these larger decisions.  Minor decisions can be managed as part of a long-term diversified risk-mitigating strategy.  The way to become better is by using tools and techniques that create a culture of constructive debate.  Initial assessments should be supplemented with independent second opinions.  

The economics of transportation equipment investment are complex.  Take a fresh look and ensure the right questions are being asked and answered.  When does it make sense to take risks? Call RESIDCO.  

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