How to improve forecasting and guard from unknown unknowns

thinking fast and slowThe Nobel laureate, Daniel Kahneman, and a group of his colleagues caught themselves making a vastly overoptimistic forecast. By asking the right questions they were able to overcome the inwardly focused forecasting approach. This true story is a good reminder for all business decision makers who need to make predictions about the future. Specifically, for mezzanine financing activities it helps those that prepare forecasts to look more from the perspective of mezzanine funds, who will be evaluating the numbers at the end of the day.

In his book, Thinking, Fast and Slow, Daniel Kahneman recalls the events that took place in 1970s. After several lengthy discussions with the Israeli Ministry of Education he was able to convince the public servants about the need to introduce judgment and decision making subject to high schools. He was then tasked with assembling a team of experts that would develop the curriculum and write the textbook. The initial team included experienced teachers, psychology students and Seymour Fox, then dean of the Hebrew University’s School of Education, who was an expert in curriculum development.

Within a year of roughly weekly meetings they all felt they had made a good progress. A detailed outline of the syllabus and a couple of chapters of the textbook were already written. They have also delivered a few sample lessons. At that time Daniel proposed an exercise – he asked everyone from the team to write down their estimate of how long it would take them to submit a finished draft of the textbook to the Ministry of Education. This approach was in line with what they were expecting to teach: the proper way to ask for information from a group is not by starting with a public discussion, but by confidentially collecting notes on each person’s judgment. It’s turned out that their predictions were all in the range between year and a half and two years and a half.

The proper way to ask for information from a group? Not a public discussion. Confidential note from each person.

The unexpected gap between inside and outside views

Once the results were seen by all of the team members Daniel turned to the expert – Seymour. He asked if Seymour knew other teams who were working on similar projects in the past and reached similar stage of curriculum development. There were several. Then, he asked about how much time it took them to complete the task and how these teams compares with the one present in the room. The shocking answer, generated based on the outside view, was that roughly 40% never finished and it took them between seven and ten years. Furthermore, on average the other groups had slightly better skills and resources, as judged by Seymour.

There was a shocking disconnect between what Seymour said and what earlier predictions were. Even Seymour himself fell prey to his inside view based on the recent progress, rather than on his more objective long-term experience. Rationally, as none of them was willing to spend six more years on the project, they should have all quit. However, after a few minutes of desperate debate, they decided that there was no immediate reason to abandon the project and carried on, despite the odds.

It took eight more years to finish the book. At the time the book was complete, Daniel was no longer part of the group, after he moved out from Israel. Unfortunately, during that time the initial support from the ministry dwindled and, eventually, the book was never put into use in high schools.[shareaholic app=”share_buttons” id=”25491281″]

Why the inside view failed and how outside view can remedy it

In their research Daniel and his colleague, Amos Tverysky, labeled the two distinctly different approaches to forecasting inside and outside views. The inside view is spontaneously adopted to evaluate the future of our projects. We tend to focus on the specific circumstances that we’re in or have recently been in. Furthermore, we look for evidence in our memory that could support the predictions. This approach can mislead even experts, like Seymour. In this story, the team had a recent experience from writing the first chapters and they knew how many more they were planning to write. Based on these, they extrapolated and maybe added a few months as a safety buffer.

This approach, however, yielded poor forecast. In the early phase of the project their motivation was probably at its highest and the earlier chapters were among the easiest ones to complete. They failed to take into account the “unknown unknowns”. With that long venture it is very likely that some unforeseen events will occur, which can cause the project to drag on for a long time: illnesses, crises of coordination and other major events affecting the lives of the team members. Some of these have occurred in this case and they not only slowed down the writing, but also resulted in periods where there was no progress at all. The chance that something will go wrong in a big project is high.

Outside view, on the other hand, is all about directing the attention away from us and, instead, on a class of similar cases. Like in this story, Seymour could easily approximate 40% failure rate once he directed his focus on other groups taking on similar projects. This was a good estimate, given that there was nothing special about their group, compared to the reference cases. Such rough estimate should serve as an anchor, which then can be further adjusted, based on new or additional information. If, for example, you were asked about the height of a man from Chicago, your first guess should be the average height of a man living in that city. If you were additionally given information that his son is a star basketball player in high school, you could adjust your estimate upwards.

Outside view and mezzanine financing

Whether you are considering mezzanine financing for your company, customer or real estate project it is imperative that you make predictions about the future cash flows. To avoid the risk of being trapped by your own enthusiasm and extrapolate future results based on insufficient evidence, try forgetting about your own project for a moment and focus on the class of similar cases. Build the general expectations based on what you would predict on average from such cases. Once you have this outside view ready, compare your own company or real estate development to the reference case. You might still expect better performance than the average, but you need to have strong evidence and good reasoning why you believe in superior results.

The outside view is also very useful when preparing for the discussions with the mezzanine funds when looking for funding. By definition, mezzanine lenders are outsiders. They will first draw on their own experience to evaluate your case. It will take time before they can learn more details about your project, thus their expectations will be first formed based on the general reference case that they will build in their own minds. Furthermore, mezzanine finance providers are typically very conservative with their estimates, therefore they tend to rely on reference cases as good indicators of what to expect. The outside view can guide your preparations for meetings or conference calls with mezzanine firms and help you understand their perspective better.

Challenging the inside view with outside view is only one of the ways in which Daniel’s book can help you while working on mezzanine financing or in business in general. There is a wealth of examples showing how our own thinking can lead to biases and irrationality. We definitely recommend reading the whole book. You can get it, for example, from Amazon by clicking here.

This article is based on the book and its excerpt that was originally published in McKinsey Insights. Additionally, you might want to watch the video below, if you want to know more about the book.

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