Styles of Thinking Impact on Financial Performance

Ground-breaking research from Cranfield School of Management has revealed that cognitive psychology can help explain financial performance in entrepreneurial businesses. The findings support the established view that risk-takers are likely to achieve the highest sales growth. The real news, however, is that they also demonstrate that owner-managers’ over-confidence in their own ability or judgment correlates with poor profit performance in their businesses. Conversely, owner-managers who display caution in using their judgment outside areas of specialist knowledge show a superior growth in their firms’ profits.

The research has been conducted among UK-based SMEs over the last three years by David Molian, co-director of CREDO, the School of Management’s Centre for Small Business Growth and Development, in collaboration with colleagues at the University of Toulouse.

We profiled the key cognitive traits of 50 owner-managers who had participated in Cranfield’s Business Growth and Development programmes between 2002 and 2004. Our focus was on their attitude to taking risks, and their tendency to be either over- or under-confident in their own judgment. The entrepreneurs were then asked to report their companies’ financial performance for the previous four years, in terms of both turnover and profitability, and this data was compared with the information on their cognitive traits. For accuracy and consistency, the same performance data was cross-referenced from the firms’ published accounts.

Psychology research has established that there are a number of cognitive biases that impact on decision-making. One of these is judgmental over-confidence, or the tendency to over-estimate the precision of one’s knowledge. Our survey tested for this factor by asking respondents to provide estimated answers to questions of both general and specialist knowledge. For example, we asked if they could estimate the age of Martin Luther King at death, using upper and lower boundaries (eg 35 years and 55 years), picking boundaries so that they were 90% confident that their answer lay between the two limits. There was no reward for pinpoint accuracy. Given sufficient questions outside areas of specific personal knowledge, respondents show patterns: those who consistently give narrow bands display excessive judgmental confidence compared with those who give broader bands.

Significant patterns emerged, leading us to conclude that there are some compelling links between how owner-managers process information and their firms’ financial performance, in terms both of profit and sales:

• There is a strong link between taking risks and sales growth. Those most open to taking risks recorded the highest sales growth, and vice-versa
• The more over-confident an entrepreneur is in his or her own judgment ability, the worse the firm’s profit performance.

Figure 1 shows the two cognitive traits plotted against sales and profit performance. In the top left box are clustered most of the top-performing companies in the survey. This combination, our survey suggests, is optimal for an ambitious owner-managed business. In the bottom right box are concentrated the slowest-growing businesses whose owner-managers will tend to struggle to grow. Profit maximisers in the bottom left box need to let go of their natural risk-aversion if they are to grow their sales¦ and those in the top right box run the risk of “busy fool” syndrome if they cannot season their judgment , while preserving their openness to risk-taking.

As a result of this research we are developing better diagnostics and improved guidance for entrepreneurs ambitious to grow their business.

Owner-managers who are more open to risk stand a much stronger chance of growing their sales. That may come as no surprise, but taking risk is no guarantee of growing profits. A crucial personality factor behind growing profitably seems to be confidence in your judgment, especially in areas outside specialist expertise. Owner-managers who are excessively confident in their judgment are significantly less likely to grow profits.The reverse holds true: if you temper your judgment with caution, you are more likely to grow your profits, relative to other owner-managed businesses.

“The correlation between confidence/over-confidence and profits is certainly news to us. It gives us an enhanced understanding of what drives financial performance, and an opportunity for owner-managers to reflect on their operating style. As a result of this we are developing better diagnostics and improved guidance for entrepreneurs ambitious to grow their business.”