Hurdle rates and other metrics based on a company's cost of capital go only so far in making investment decisions, as every CFO knows. That means effective allocation requires at least a bit of gut instinct. But how to apply it?
Contrary to some notions, instincts of this sort are not uninformed, knee-jerk reactions, most experts say. Instead, they reflect an abiding knowledge that needn't be brought consciously to bear on a decision but instead can be relied on without second thought. But what's the difference?
"A gut instinct is intuitively or unconscientiously knowing what decision to make," explained Eric Darr, executive vice president and provost at Harrisburg University of Science and Technology.
In a recent article, How to test your decision-making instincts, for McKinsey Quarterly, authors Andrew Campbell and Jo Whitehead say executives should test their gut instincts only when four tests are met. The familiarity test: Have we frequently experienced identical or similar situations? Familiarity is important because our subconscious works on pattern recognition. If we have plenty of appropriate memories to scan, our judgment is likely to be sound, wrote the authors.
Secondly, there is the feedback test. Did we get reliable feedback in past situations? Previous experience is useful to us only if we learned the right lessons. At the time we make a decision, our brains tag it with a positive emotion - recording it as a good judgment. Without reliable feedback, our emotional tags can tell us that our past judgment was good, even though an objective assessment would record them as bad.
Test number three is the measured-emotions test: are the emotions we have experienced in similar or related situations measured? If a situation brings to mind highly charged emotions, these can unbalance our judgment.
Lastly, wrote the authors, do you pass the independence test - are we likely to be influenced by any inappropriate personal interests or attachments? If a situation fails even one of these four tests, strengthen the decision process to reduce the risk of a bad outcome. How to do this: stronger governance, additional experience and data, or more dialogue and challenge, say the authors.
Linda Henman, president of Henman Performance Group, says CFOs should ask themselves three key questions: "Do you want to make this change because of the rewards it may bring or the excitement it will bring?" If the answer is the former, go for it, Henman says. But wait if the reply is the latter.
Secondly, she says, "What does your track record tell you? Have you been happy when you've listened to your instincts?" And, "Do you miss opportunities because you err on the side of caution too often?"
A select few can think without thinking, but most people should gather data more carefully, engage others in the decision making process, anticipate consequences and outline worst case scenarios, she added.
As noted in Aon's 2010 Global Enterprise Risk Management Survey, 43 percent of organizations new to ERM still base their risk decisions on gut instinct, according to Michael Joiner, senior consultant in ERM, Aon Global Risk Consulting. However, none of the advanced ERM practitioners reported using gut feeling as a decision making tool. Fifty percent of organizations in advanced stages of ERM programs have switched to quantifiable data for risk decisions at the enterprise level, and 43 percent reported using financial and operational industry benchmarks as well.
But there are limitations to those benchmarks, leaving CFOs no choice but to trust their gut to at least one degree or another. And despite the cautions against knee-jerk reactions, good gut instincts may be hard to distinguish from those, says Andrew Appel, a consultant with Beyond Success Coaching: "If you ask yourself what is the right action to take," says Appel, "it is the answer that comes up immediately, in less than a fraction of a fraction of a second. The millisecond test is the ultimate test."
In other words, trusting your gut will never be easy, however necessary it may be.