'Not for Free': Saul J. Berman on Creating New Revenue Models

The "phenomenon of free" has hit many businesses hard, particularly media businesses, argues Saul J. Berman, Global & Americas Leader for the IBM Strategy & Change Consulting Group within IBM Global Business Services (GBS). In Not for Free: Revenue Strategies for a New World, Berman offers lessons from businesses that have integrated successful business model innovations -- including Google, Amazon, Apple, Redbox and Hulu -- as well as from businesses that have failed to do so. Recently, Knowledge@Wharton and Jerry (Yoram) Wind sat down with Berman to discuss his thoughts on who pays for free content and why new models are essential for success.

The following is an edited version of that conversation.

Knowledge@Wharton: Saul, thank you so much for joining us today.

Saul J. Berman: Thank you for having me. I appreciate the opportunity.

Knowledge@Wharton: In 2008,Chris Anderson, the editor of Wired, wrote a very famous article that was titled, "Free: Why $0.00 Is the Future of Business." Based on the book that you have just written, was he right or wrong?

Berman: Well, it depends on how you want to interpret the question. He suggested that content would increasingly be free and that free was a much better price than near-free. I argue that somebody is paying for it somewhere. So, in some cases it may be free to the end consumer, but the point is that it is not really free. It is being paid for: maybe by an advertiser, maybe by a sponsor, maybe by somebody who wants access to a group of people for other purposes or somebody who is bundling it with other products or services they offer. But in one form or another, it is not free. Somebody is paying for it and somebody is seeing that the people who create the content will continue to create that content and be reimbursed for it.

In the case of the music industry, which was one of the first examples of disruption, we can see in our analysis that music is worth more than it ever was. It just doesn't go to the music companies anymore. The value of music goes to the people who make devices for you to listen to your music on. It goes to the cell phone companies that enable you to download music. It goes to the concert promoters. Since there is more sharing of music out there, people know more about the artists, which, in many cases, means the attendance for concerts has gone up. Overall, the amount of revenue has actually increased, and it is really not for free, though it may at times be free -- or perceived to be free, not that that's appropriate or legal -- to the end consumer. Though, again, there has always been advertising. Some of these models have always been out there, where you can get things without direct payment.

Knowledge@Wharton: Let me push back very gently on this issue.Let's take a company like Google that provides Gmail for free. It helps to build a massive audience. It does not directly charge the consumer, but at the same time, it is able to monetize the traffic through the advertising that it is able to sell alongside the emails. Is there anything wrong with that sort of a model?

Berman: Well, when you say "wrong," I am not sure we are into qualitative judgments, ethical judgments or economic arguments here. From an economic perspective, people are in business generally to make money, so somebody is making money out of the equation. The people who are creating the content are somehow making money, or they wouldn't be able to sustain their business in the long term.

So, again, back to my music company example. If the music companies themselves don't find a way to monetize the content they are involved with, either they won't be part of the equation or they will have to participate more so than they do today in some of these other revenue streams.

We argue not only about how much money is associated with content, but also who gets that money. In many cases, what we are seeing is the money shifting to other people because the business models are changing.

Knowledge@Wharton: But in Google's case, it is still Google that makes the money -- just not on the email, but on the advertising. That's where the question comes up. What's wrong with that?

Berman: I don't see anything wrong with that. That is a business model or business proposition. I use the example in the book of the Gillette razor blade model. Historically, Gillette gave you the razor for free -- or near free -- and you paid forever for the expensive blades, on which they made a very nice profit. Well, what Apple did when they created the first iToy, as I call it -- the iPod -- they gave you the music for free -- or near free -- 99 cents. That was the equivalent of the blades. They shared that money with the music companies very nicely -- 70% or 75%. But all of a sudden the razor -- or the device to listen to the music on -- became very expensive and they kept all the money on that. So they shifted the proposition. There's the opportunity in each of these innovations around different mechanisms for compensation, whether they be payer, pricing or a different model. There are going to be opportunities for the value to shift.

Knowledge@Wharton: Jerry, do you think that sometimes what is perceived to be free is actually paid for -- but in terms of information rather than cash? Is there any value to that?

Wind: The question is from whose point of view.

Berman: Right.

Wind: If you look at it from the consumer point of view, I would suspect most consumers will perceive the products that they get for free as free because they don't see the advertisement as a payment. From a consumer point of view, free may be a great component of the value proposition of deferring. But I think the key point that Saul is making -- and which I really like in the book -- is the idea that [it is important to] start paying attention to the business model and the revenue model, and to ask, how are you going to make money eventually?

Google is a great example. The overall Google proposition -- or the business model -- is still very valid. They make money off of this. Can they make more money if they start charging for Gmail or for some of the other components? That is a different question. But there is real value in focusing the attention of management on what your revenue model is. How are you going to make money? Look at this in the broader context.

Berman: You have to look at, as Jerry is saying, the broader consumer experience. That experience is the combination of content, hardware and software. It is the integration of those pieces and the creation of the experience that often gets the value. The challenge is who is going to control that value in these different mechanisms for monetizing. Is it going to be the hardware company? Is it going to be the software company? Is it going to be the content company? Is it going to be a fourth party that puts all those propositions together? That is where the interesting challenge is and the opportunity to make more money even if, as you say, it may be free to the end consumer in terms of the direct pricing model. There may be indirect payment by somebody else or otherwise to monetize.

Knowledge@Wharton: I know you focus a lot on workable business models in your book. When it comes to business models for information goods, do you think that free could be one price point along a continuum of prices for information goods?

Berman: Well, yes. There can be a free-to-the-consumer model for the basic service, and then you try to get everybody to trade up to what Chris calls a "Freemium" model, where you charge more for additional services. Take an automobile, which we talk about in the book as well. The value-add in an automobile includes the sensors, actuators and intelligent information that comes from them.

So we can now provide help with navigation. We can provide entertainment services. We can provide concierge or restaurant reference services in the car now. Increasingly, just like the car companies may have made money in the past for selling you after-market service on your vehicle, now they have improved the quality of the vehicle, and they may make more money from these subscription-based entertainment or other types of concierge and information services. That may be where they make a lot of their money in the future.

Now who gets the money out of that is still an open question. But the adoption of the information sensors, actuators and connectivity -- those devices can now control the refrigerator or the washing machine or the heat or the security system in your house at the same time. So there is a world of possibility opening up and the question is, how will that work as every product becomes more information-based?

Knowledge@Wharton: One industry that has been hugely disrupted by free content is, of course, the publishing industry. What are your thoughts on survival strategies?

Berman: I would like to hear what Jerry has to say on this one.

Wind: First of all, let's link it back to the previous question in terms of digital product or information product in a single price or continuum. I don't see really any distinction between information products -- or digital products, in general -- and regular products in terms of product line when you have to start thinking about a product line offering. The product line can be from free to whatever price it is. The key is going back to what Saul was describing before -- the move from product to service to integrated offering, a tall solution, and, most importantly, the customer experience. Each one of these is a value of social business and, therefore, the willingness of a given segment to pay for this.

The same thing is true in the publishing area. People still want to hear, read and find out about the news. They just don't want to read it in the traditional form. There is also a segment that may be lagging behind -- a segment like me. I still like to read The New York Times on paper and for the feel, but I am part of a shrinking segment. What you have to realize is that the market is heterogeneous. That's one of the key things we know about marketing. Therefore, you want to offer the news in a variety of ways. Furthermore, it is a re-definition of news. What is a newspaper? Is it only news? Is it entertainment? What is the nature of the offering? I think the publishing industry is now in a situation where they see an opportunity to re-invent themselves, to ask, what is the value proposition? What are we trying to offer consumers and how do we integrate news with entertainment?

From some data we have seen, my understanding is that younger people get most of their news from Jon Stewart. What is the competition of the newspaper to a Jon Stewart--type show and delivery? It is a great opportunity to innovate -- a great opportunity to rethink what publishing is and what it is we are trying to do.

In general, I think that Saul's book offers a great opportunity for companies to reinvent themselves and to rethink how they can come out with a more innovative solution. You will not be able to innovate if you just stay within the boundaries of your old industry definition. By rethinking business models and revenue models, there is a great opportunity for innovation.

Berman: Let me give you one of my favorite examples, which is the music industry example again. The industry was under all this pressure. Albums sold from $9.99 typically online. Songs sold for 99 cents until the industry got Steve Jobs to let them raise that price a little. But a ring tone, which is a 10-second clip of a 99-cent song, people were paying $2, $3, $4 or $5 for. Now bits of your overall content are worth more than the whole. That is a pretty good business model if you can make it work.

If you are a book publisher or a newspaper publisher, increasingly you are able to take the archive, and you are able to monetize content from [it], in some cases, for more than the original newspaper or the original magazine would have cost you -- or a chapter in a book for more than what the Amazon price on that book might have been.

Knowledge@Wharton: I would love to get your thoughts on one other area. If you look at what has been happening recently among young people in the Middle East, the vast majority of them have been getting their information not from newspapers, magazines or even radio or television. They have been getting it from Facebook and Twitter, especially because of the curbs that the government put on the Internet. Both of those happen also to be free services. How, then, should people think about revenue-generating models in publishing?

Berman: First of all, they are not, in my terms, totally free. Facebook makes a lot of money from advertising, though many people don't realize it is even there. But they are making a lot of money on it. So, again, it is being monetized. The other point is as you get more of that information and use it, it is creating stars. It is creating new vehicles around the people who become famous for sharing content over these services. Those people are finding other ways to monetize the celebrity or the status that they have created by being an authoritative source who contributed to something. So both the provider and the individual are increasingly going to find ways to monetize, or they are going to have to find something else to do with their time.

Knowledge@Wharton: Do you think that, in publishing, content creators are being eclipsed by what are called "content curators"? And what are the implications?

Berman: Interesting question. We do think there is a big role for curation as a value-added service. We think there is a big role for analytics. Companies like Bloomberg have long created value around the analytics. We have told people in the information publishing space, beginning five years ago, that they have to do more than just, if you will, provide the information. They have to provide people the tools and capabilities to do different things with that information and they have to provide analysis and insight.

Increasingly, it gets back to the point we make about the experience. There are lots of different ways to monetize, which we outline in the book. You can monetize with different audiences in different ways.

Knowledge@Wharton: Just one last question: You have examples in your book about innovative business models involving Progressive, Redbox and so forth. Could you give us some more examples?

Berman: Sure. Obviously we are all familiar with some of the ones in the music space where now you can buy singles. You can buy ring tones. You can buy à-la-carte individual tracks. But companies, like Netflix, came along and turned what was a pay-per-view or buy media experience into a rental media experience. Redbox came along and provided a less service-oriented, go-to-a-vending-machine, lower-price way to get that content. So we talk about the idea of variable pricing. You can sell different things to different people at different times.

The airlines go further with dynamic pricing. They will sell not only different things to different people at different times, but the price will change at different days or times of the day. So there are lots of different ways. What is new is that you take them to another industry in many cases. We talk about Zipcar in the book. Instead of buying a car or leasing a car, you can subscribe and rent it by the hour, by the day, or whatever you want. You get charged for your usage of that vehicle, and the vehicles are staggered all over and you can go use them.

There are examples of advertising in spaces where they have never been used before, such as the phone business. Instead of paying for information services, you can listen to an ad and get free information services. Even in industries such as medical, now we are seeing people experiment with pricing based on results. In some cases, where drugs have not been approved by insurance companies, some of the medical drug companies are experimenting with, "You pay us if it gets results for you." If it is in the experimental stage and hasn't been approved and your insurance company won't pay it, take the drug. If it lowers your whatever and improves your medical condition, then pay us for it.

So some of these models -- or most of them -- have always been around some place. The challenge is now applying them in different ways to different businesses. In the book, we categorize them into three categories.

The first category is pricing, where you change the direct price and the way you price to the end consumer. This applies in a B-to-B world as well, where we used to invest in assets and build capabilities in companies. Today, we might outsource them and pay somebody over time. We are still paying, but we are paying in a different way.

Payer innovation is the second category, where someone other than yourself pays. We are seeing many more ways to do advertising, sponsorship or performance-based types of payment that are indirect and from other people.

And, finally, package innovation, where you package it with something else or sell the parts as we suggested in the cell phone or the publishing case. What we think is the real challenge for most companies is they are going to have to have multiple ways of monetizing for different consumer segments who will want to pay in different ways. Some will say, in effect, "I want it to be free to me. I will pay in some other form." Others will pay directly: "I don't want the advertising. I don't want anybody having my name." Even there, there are going to be different ways of doing it. As I say, the challenge is how do you do this in a way that makes sense to the different segments and then be able to manage that complexity in your business?

Knowledge@Wharton: Saul, thank you so much for speaking with us.

Berman: It has been a pleasure. I appreciate the opportunity. Please send me a note if you have any questions at Saul.Berman@us.ibm.com, and please let me know what you think of Not For Free.

http://knowledge.wharton.upenn.edu/article.cfm?articleid=2817

New Approach to Ads in Games

As the number of people playing videogames on smartphones surges, two new companies are touting a way for advertisers to reach the potential customers—without annoying them.
The start-ups, Kiip Inc. and Tap.Me Inc., are moving beyond the familiar mobile banner ads, letting marketers sponsor rewards or extra tools within the game. The idea is that users will then associate the brand with a positive experience.

When a player on a game that uses Kiip (pronounced "keep") hits a certain milestone, a message pops up saying that the person can also get a real-world reward—like a six-pack of soda free or a coupon for flowers on Mother's Day. The person can redeem the reward then or later, or email it to someone else.
"It's the moment where you feel like you've accomplished something. We match it with something that's branded," said Kiip's 20-year-old founder, Brian Wong.
Kiip uses algorithms to decide when to offer the deals, so weaker players can still get rewards and people won't be conditioned to expect prizes at certain times.
Chicago-based Tap.Me, on the other hand, lets brands sponsor in-game tools and rewards, but only if players choose them. With Tap.Me, advertisers can enter keywords and be matched to suggested tools and games they should sponsor.
For example, a restaurant chain that wants to tout its value menu might sponsor a tool that helps players get coins in the game. Once players choose that tool, the brand can send other rewards, like coupons, to the player's inbox.
Tap.Me signed its first official customer in May with Coinstar Inc.'s Redbox DVD kiosk service. Other brands, including the Wm. Wrigley Jr. Co., are in discussions with the start-up, which is on games with 5.7 million players now, including the popular "Charmed." It expects to reach more than 40 million players by the end of the year. The companies said they were still working out details of what the brands would offer in the games.
Founded about a year ago, Kiip began testing ads on games in April and has handled campaigns from Dr Pepper Snapple Group Inc., beauty product store Sephora USA Inc. and 1-800-Flowers.com Inc., among others. The company, which is based in San Francisco, says it has more than 12 million active players on 15 games.
Kiip is still testing the response to its ads and hasn't yet disclosed the games it is using. Eventually games using the start-up's system will say "Kiip enabled" as a selling point, Mr. Wong said.
Both start-ups are in talks with game makers to get on more games and share a percentage of revenues.
The effort to capture gamers' attention comes as mobile games become a popular pastime. According to measurement firm Nielsen, 74% of people who have Apple Inc.'s iPhone played games on the phone in the past month, and 66% of those with phones running Google Inc.'s Android system had played.
Advertising has long been present in regular videogames, but mostly as "product placement" such as messages that appear on billboards in a driving game. Traditional gamers have balked at seeing any ads at all in expensive console games, but that isn't the case in cheaper mobile apps, said Noah Elkin, a principal analyst at research firm eMarketer.
Also, unlike traditional videogames, mobile games appeal to women as well as men—thus drawing interest from brands that wouldn't have ordinarily advertised in a game. "Casual games are perennially popular especially with women, and you can reach an older audience as well," said Mr. Elkin.
But mobile advertising is still a nascent field. EMarketer estimates that in the U.S., spending on mobile ads will be about $1.1 billion this year, a small number compared with the more than $150 billion expected to be spent on advertising in general.
Mr. Elkin said that the trend on mobile devices is to move beyond banner ads, in an effort to get people to engage more with the advertising. "Most advertisers are still spending the bulk of their display dollars on traditional banners, but if you look at where the steeper growth is, it's at the richer end of the media: video, interactive," he said.
The start-up founders all believe that many people either ignore banner ads or are bothered by them—particularly in games, if they hit an ad by mistake and it takes them to a new screen.
"Something that we discovered very early on was that ads needed to take advantage of the natural game design" and not interrupt the game, said Tap.Me Chief Executive Joshua Hernandez.
"Mobile advertising is growing by leaps and bounds, but the manner in which brands connect to consumers is the real key" when it comes to making mobile advertising successful, said Bob Rupczynski, global director of interactive marketing at Wrigley, which has been in discussions with Tap.Me.
The advertisers evaluating the in-game advertising technology said they hope associating themselves with pleasant parts of the game and offering rewards will provide that connection.
It's still too early to tell whether the strategy will work. Kiip says its tests show that 30% to 50% of people take advantage of the rewards. Likewise, Tap.Me says it's too early to have hard numbers on its effectiveness, although its tests show that users engage with sponsors about 15% of the time.

http://professional.wsj.com/article/SB10001424052702304231204576403403508609600.html

How the growth of emerging markets will strain global finance

Surging demand for capital, led by developing economies, could put upward pressure on interest rates and crowd out some investment.

Short-term doldrums aside

, the world’s corporations would seem to be in a strong position to grow as the global economy recovers. They enjoy healthy cash balances, with $3.8 trillion in cash holdings at the end of 2009, and they have access to cheap capital, with real long-term interest rates languishing near 1.5 percent. Indeed, as developing economies continue to pick up the pace of urbanization, the prognosis for companies that can tap into that growth over the next decade looks promising.
Yet all those new roads, ports, water and power systems, and other kinds of public infrastructure—and the many companies building new plants and buying machinery—may put unexpected strains on the global financial system. The McKinsey Global Institute’s (MGI) recent analysis finds that by 2030, the world’s supply of capital—that is, its willingness to save—will fall short of its demand for capital, or the desired level of investment needed to finance all those projects.1 Indeed, household saving rates have generally declined in mature economies for nearly three decades, and an aging population seems unlikely to reverse that trend. China’s efforts to rebalance its economy toward increased consumption will reduce global saving as well.
The gap between the world’s supply of, and demand for, capital to invest could put upward pressure on real interest rates, crowd out some investment, and potentially act as a drag on growth. Moreover, as patterns of global saving and investment shift, capital flows between countries will likely change course, requiring new channels of financial intermediation and policy intervention. These findings have important implications for business executives, investors, government policy makers, and financial institutions alike.

Surging demand for capital

Several economic periods in history have required massive investment in physical assets such as infrastructure, factories, and housing.2 These eras include the industrial revolution and the post–World War II reconstruction of Europe and Japan. We are now at the beginning of another investment boom, this time fueled by rapid growth in emerging markets.
Across Africa, Asia, and Latin America, the demand for new homes, transport systems, water systems, factories, offices, hospitals, schools, and shopping centers has already caused investment to jump. The global investment rate increased from a recent low of 20.8 percent of GDP in 2002 to 23.7 percent in 2008 but then dipped again during the global recession of 2009. The increase from 2002 through 2008 resulted primarily from the very high investment rates in China and India but reflected higher rates in other emerging markets as well. Considering the very low levels of physical-capital stock these economies have accumulated, our analysis suggests that high investment rates could continue for decades.
In several scenarios of economic growth, we project that global investment demand could exceed 25 percent of GDP by 2030. To support growth in line with the forecasters’ consensus, global investment will amount to $24 trillion in 2030, compared with about $11 trillion in 20083 (Exhibit 1). When we examine alternative growth scenarios, we find that investment will still increase from current levels, though less so in the event of slower global GDP growth.

The mix of global investment will shift as emerging-market economies grow. When mature economies invest, they are largely upgrading their capital stock: factories replace old machinery with more efficient equipment, and people make home improvements. But the coming investment boom will involve relatively more investment in infrastructure and residential real estate. Consider the fact that emerging economies already invest in infrastructure at a rate more than two times higher than that of mature economies (5.7 percent of GDP versus 2.8 percent, respectively, in 2008). The gap exists in all categories of infrastructure but is particularly large in transportation (for instance, roads, airports, and railways), followed by power and water systems. We project global investment demand of about $4 trillion in infrastructure and $5 trillion in residential real estate in 2030, if the global economy grows in line with the consensus of forecasters.

A decline in savings

The capital needed to finance this investment comes from the world’s savings. Over the three decades or so ending in 2002, the global saving rate (saving as a share of GDP) fell, driven mainly by a sharp decline in household saving in mature countries. The global rate has increased since then, from 20.5 percent of GDP in 2002 to 24 percent in 2008, as household saving rebounded in mature economies and many of the developing countries with the highest rates—particularly China—have come to account for a growing share of world GDP. Our analysis suggests, however, that the global saving rate is not likely to rise in the decades ahead, as a result of several structural shifts in the world economy.
First, China’s saving rate will probably decline as it rebalances its economy so that domestic consumption plays a greater role. In 2008, China surpassed the United States as the world’s largest saver, with the national saving rate reaching over 50 percent of GDP. But if China follows the historical experience of other countries, its saving rate will decline over time as the country grows richer, as happened in Japan, South Korea, Taiwan, and other economies (Exhibit 2). It is unclear when this process will begin, but already the country’s leaders have started to adopt policies that will increase consumption and reduce saving.4 If China succeeds at increasing consumption, it would reduce the 2030 global saving rate by around two percentage points compared with 2007 levels—or about $2 trillion less than China would have accumulated by 2030 at current rates.

Moreover, expenditures related to aging populations will increasingly reduce global saving. By 2030, the proportion of the population over the age of 60 will reach record levels around the world. The cost of providing health care, pensions, and other services will rise along with the ranks of the elderly. Recent research suggests that spending for the retired could increase by about 3.5 percentage points of global GDP by 2030.5 All of this additional consumption will lower global saving, either through larger government deficits or lower household and corporate saving.
Skeptics may point out that households in the United States and the United Kingdom have been saving at higher rates since the 2008 financial crisis, especially through paying down debt. In the United States, household saving rose to 6.6 percent of GDP in the second quarter of 2010, from 2.8 percent in the third quarter of 2005. In the United Kingdom, saving rose from 1.4 percent of GDP in 2007 to 4.5 percent in the first half of 2010. But even if these rates persist for two decades, they would increase the global saving rate by just one percentage point in 2030—not enough to offset the impact of increased consumption in China and of aging.
Together, these trends mean that if the consensus forecasts of GDP growth are borne out, the global supply of savings will be around 23 percent of GDP by 2030, falling short of global investment demand by $2.4 trillion. This gap could slow global GDP growth by around one percentage point a year. What’s more, sensitivity analysis of several scenarios suggests that a similar gap occurs even if China’s and India’s GDP growth slows, the world economy recovers more slowly than expected from the global financial crisis, or other plausible possibilities transpire, such as exchange-rate appreciation in emerging markets or significant global investment to combat and adapt to climate change (Exhibit 3).

Implications

Our analysis has important implications for both business leaders and policy makers. Businesses and investors will have to adapt to a new era in which capital costs are higher and emerging markets account for most of the world’s saving and investment. Governments will play a vital role in setting the rules and creating the conditions that could facilitate this transition.

Higher capital costs

Nominal and real interest rates are currently at 30-year lows, but both are likely to rise in coming years. If real long-term interest rates returned to their 40-year average, they would rise by about 150 basis points from the level seen in the autumn of 2010. The growing imbalance between the supply of savings and the demand for investment capital will be significant by 2020. However, real long-term rates—such as the real yield on a ten-year bond—could start rising even within the next five years as investors anticipate this structural shift. Furthermore, the move upward isn’t likely to be a one-time adjustment, since the projected gap between the demand for and the supply of capital widens continuously from 2020 through 2030.
Capital costs could easily go even higher. Real interest rates can also include a risk premium to compensate investors for the possibility that inflation might increase more than expected. History shows that real interest rates rise when investors worry about the possibility of unexpected spikes in inflation. Today, investors are beginning to anticipate higher inflation resulting from expansive monetary policies that major governments have pursued.
Finally, as the recent crisis demonstrated, short-term capital isn’t always available in a capital-constrained world. Companies should seek more stable (though also more expensive) sources of funding, reversing the trend toward the increasing use of short-term debt over the past two decades. The portion of all debt issued for maturities of less than one year rose from 23 percent in the first half of the 1990s to 47 percent in the second half of the 2000s. Financing long-term corporate investments through short-term funding will be riskier in the new world, compared with financing through equity and longer-term funding. To better align incentives, boards should revisit some of their inadvertent debt-oriented biases, such as using earnings per share (EPS) as a performance metric.

Changing business models

If capital costs increase, companies with higher capital productivity—greater output per dollar invested—will enjoy more strategic flexibility because they require less capital to finance their growth. Companies with direct and privileged sources of financing will also have a clear competitive advantage. Traditionally, this approach meant nurturing relationships with major financial institutions in financial hubs such as London, New York, and Tokyo. In the future, it might also mean building ties with additional sources of capital, such as sovereign-wealth funds, pension funds, and other financial institutions from countries with high saving rates.
Moreover, for companies whose business models rely on cheap capital, an increase in real long-term interest rates would significantly reduce their profitability, if not undermine their operations. The financing and leasing arms of consumer-durables companies, for example, would find it increasingly difficult to achieve the high returns of the recent past as the cost of funding increases. Companies whose sales depend on easily available consumer credit would find growth harder to achieve.

Shifting investor strategies

Investors will want to rethink some of their strategies as real long-term interest rates rise. In the short term, any increase in interest rates will mean losses for current bondholders. But over the longer term, higher real rates will enable investors to earn better returns from fixed-income investments than they have in the years of cheap capital. This change could shift some investment portfolios back to traditional fixed-income instruments and deposits and away from equities and alternative investments.
For pension funds, insurers, endowments, and other institutional investors with multidecade liabilities, the world’s growing infrastructure investment could be an attractive opportunity. Many of these institutions, however, will need to improve their governance and incentive structures, reducing pressure to meet quarterly or annual performance benchmarks based on mark-to-market accounting and allowing managers to focus on longer-term returns. This change would be required as institutions come to manage portfolios with a growing proportion of less liquid, long-term investments, since volatility in market prices may reflect market liquidity conditions rather than an investment’s intrinsic, long-term value.6
Emerging markets, though they may present attractive opportunities, also pose many risks and complexities, and returns could vary significantly across countries. As incomes in emerging markets rise and capital markets develop, nonfinancial businesses can expect healthy growth from investing in both physical and financial assets. Returns to financial investors are less certain, however, particularly in countries with low returns on capital or savings trapped in domestic markets by capital controls or a “home bias” among domestic savers and investors.7 These countries will remain susceptible to bubbles in equity, real-estate, and other asset markets, with valuations exceeding intrinsic levels. Foreign investors will need to assess valuations carefully before committing their capital. They will also have to take a long-term perspective, since volatility in these bubble-prone markets may remain higher than it is in the developed world.

A call for government action

Governments will need to encourage the flow of capital from the world’s savers to places where it can be invested in productive ways while minimizing the risks inherent in closely intertwined global capital markets. Governments in countries with mature markets should encourage more saving and domestic investment, rebalancing their economies so they depend less on consumption to fuel growth. Policy makers in these countries, particularly the United Kingdom and the United States, should start by putting in place mechanisms to sustain recent increases in household saving. They could, for instance, implement policies that encourage workers to increase their contributions to saving plans, enroll in pension plans, and work longer than the current retirement age. Further, governments can themselves contribute to gross national savings by cutting expenditures.
To replace consumption as an engine of economic growth, governments in these countries also should adopt measures aimed at boosting domestic investment. They could, for example, provide accelerated tax depreciation for corporations, as well as greater clarity on carbon pricing—the current uncertainty is holding back clean-tech investment. They should also address their own infrastructure-investment backlog, although this could require them to revise government accounting methods that treat investment and consumption in the same way.
In emerging economies, governments should promote the continued development of deep and stable financial markets that can effectively gather national savings and channel funds to the most productive investments. Today, the financial systems in emerging markets generally have a limited capacity to allocate savings to users of capital. We see this in these countries’ low level of financial depth—or the value of domestic equities, bonds, and bank deposits as a percentage of GDP.8 Policy makers should also create incentives to extend banking and other financial services to the entire population.
At the same time, policy makers around the world should create the conditions to promote long-term funding and avoid financial-protectionist measures that obstruct the flow of capital. This will require removing constraints on cross-border investing, whether through restrictions on pension funds and other investors or on capital accounts. Policy makers must also create the governance and incentives that enable managers of investment funds with long-term liabilities, such as pension funds, insurance companies, and sovereign-wealth funds, to focus on long-term returns and not on quarterly results that reflect market movements and can deviate from long-term valuations.
At this writing, global investment already appears to be rebounding from the 2009 recession. The outlook for global saving is less certain. A climate of costlier credit will test the entire global economy and could dampen future growth. The challenge for leaders will be to address the current economic malaise and simultaneously create the conditions for robust long-term growth for years to come.

https://www.mckinseyquarterly.com/Corporate_Finance/Capital_Management/How_the_growth_of_emerging_markets_will_strain_global_finance_2715?gp=1

http://i-connectx.net/node/185

Strategic decisions: When can you trust your gut?

Nobel laureate Daniel Kahneman and psychologist Gary Klein debate the power and perils of intuition for senior executives.

MARCH 2010

In This Article

• Sidebar: Overconfidence in action?

• About the authors
• Comments

For two scholars representing opposing schools of thought, Daniel Kahneman and Gary Klein find a surprising amount of common ground. Kahneman, a psychologist, won the Nobel Prize in economics in 2002 for prospect theory, which helps explain the sometimes counterintuitive choices people make under uncertainty. Klein, a senior scientist at MacroCognition, has focused on the power of intuition to support good decision making in high-pressure environments, such as firefighting and intensive-care units.

In a September 2009 American Psychology article titled “Conditions for intuitive expertise: A failure to disagree,” Kahneman and Klein debated the circumstances in which intuition would yield good decision making. In this interview with Olivier Sibony, a director in McKinsey’s Brussels office, and Dan Lovallo, a professor at the University of Sydney and an adviser to McKinsey, Kahneman and Klein explore the power and perils of intuition for senior executives.

The Quarterly: In your recent American Psychology article, you asked a question that should be interesting to just about all executives: “Under what conditions are the intuitions of professionals worthy of trust?” What’s your answer? When can executives trust their guts?

Gary Klein: It depends on what you mean by “trust.” If you mean, “My gut feeling is telling me this; therefore I can act on it and I don’t have to worry,” we say you should never trust your gut. You need to take your gut feeling as an important data point, but then you have to consciously and deliberately evaluate it, to see if it makes sense in this context. You need strategies that help rule things out. That’s the opposite of saying, “This is what my gut is telling me; let me gather information to confirm it.”

Daniel Kahneman: There are some conditions where you have to trust your intuition. When you are under time pressure for a decision, you need to follow intuition. My general view, though, would be that you should not take your intuitions at face value. Overconfidence is a powerful source of illusions, primarily determined by the quality and coherence of the story that you can construct, not by its validity. If people can construct a simple and coherent story, they will feel confident regardless of how well grounded it is in reality.

The Quarterly: Is intuition more reliable under certain conditions?

Gary Klein: We identified two. First, there needs to be a certain structure to a situation, a certain predictability that allows you to have a basis for the intuition. If a situation is very, very turbulent, we say it has low validity, and there’s no basis for intuition. For example, you shouldn’t trust the judgments of stock brokers picking individual stocks. The second factor is whether decision makers have a chance to get feedback on their judgments, so that they can strengthen them and gain expertise. If those criteria aren’t met, then intuitions aren’t going to be trustworthy.

Most corporate decisions aren’t going to meet the test of high validity. But they’re going to be way above the low-validity situations that we worry about. Many business intuitions and expertise are going to be valuable; they are telling you something useful, and you want to take advantage of them.

Daniel Kahneman: This is an area of difference between Gary and me. I would be wary of experts’ intuition, except when they deal with something that they have dealt with a lot in the past. Surgeons, for example, do many operations of a given kind, and they learn what problems they’re going to encounter. But when problems are unique, or fairly unique, then I would be less trusting of intuition than Gary is. One of the problems with expertise is that people have it in some domains and not in others. So experts don’t know exactly where the boundaries of their expertise are.

The Quarterly: Many executives would argue that major strategic decisions, such as market entry, M&A, or R&D investments, take place in environments where their experience counts—what you might call high-validity environments. Are they right?

Gary Klein: None of those really involve high-validity environments, but there’s enough structure for executives to listen to their intuitions. I’d like to see a mental simulation that involves looking at ways each of the options could play out or imagining ways that they could go sour, as well as discovering why people are excited about them.

Daniel Kahneman: In strategic decisions, I’d be really concerned about overconfidence. There are often entire aspects of the problem that you can’t see—for example, am I ignoring what competitors might do? An executive might have a very strong intuition that a given product has promise, without considering the probability that a rival is already ahead in developing the same product. I’d add that the amount of success it takes for leaders to become overconfident isn’t terribly large. Some achieve a reputation for great successes when in fact all they have done is take chances that reasonable people wouldn’t take.

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	Overconfidence in action? A December 2009 survey of 463 readers of mckinseyquarterly.com underscored the degree to which senior executives sometimes exhibit greater confidence than those further down in the organization. In response to the question “Does management admit mistakes and kill unsuccessful initiatives in a timely manner?” 80 percent of C-level executives said yes. In contrast, only 49 percent of non-C-level executives agreed with the same statement. Executives responded to the survey after reading “Competing through organizational agility,” by London Business School professor Don Sull.

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Gary Klein: Danny and I are in agreement that by the time executives get to high levels, they are good at making others feel confident in their judgment, even if there’s no strong basis for the judgment (see sidebar, “Overconfidence in action?”).

The Quarterly: So you would argue that selection processes for leaders tend to favor lucky risk takers rather than the wise?

Daniel Kahneman: No question—if there’s a bias, it’s in that direction. Beyond that, lucky risk takers use hindsight to reinforce their feeling that their gut is very wise. Hindsight also reinforces others’ trust in that individual’s gut. That’s one of the real dangers of leader selection in many organizations: leaders are selected for overconfidence. We associate leadership with decisiveness. That perception of leadership pushes people to make decisions fairly quickly, lest they be seen as dithering and indecisive.

Gary Klein: I agree. Society’s epitome of credibility is John Wayne, who sizes up a situation and says, “Here’s what I’m going to do”—and you follow him. We both worry about leaders in complex situations who don’t have enough experience, who are just going with their intuition and not monitoring it, not thinking about it.

Daniel Kahneman: There’s a cost to not being John Wayne, since there really is a strong expectation that leaders will be decisive and act quickly. We deeply want to be led by people who know what they’re doing and who don’t have to think about it too much.

The Quarterly: Who would be your poster child for the “non–John Wayne” type of leader?

Gary Klein: I met a lieutenant general in Iraq who told me a marvelous story about his first year there. He kept learning things he didn’t know. He did that by continuously challenging his assumptions when he realized he was wrong. At the end of the year, he had a completely different view of how to do things, and he didn’t lose credibility. Another example I would offer is Lou Gerstner when he went to IBM. He entered an industry that he didn’t understand. He didn’t pretend to understand the nuances, but he was seen as intelligent and open minded, and he gained trust very quickly.

The Quarterly: A moment ago, Gary, you talked about imagining ways a decision could go sour. That sounds reminiscent of your “premortem” technique. Could you please say a little more about that?

Gary Klein: The premortem technique is a sneaky way to get people to do contrarian, devil’s advocate thinking without encountering resistance. If a project goes poorly, there will be a lessons-learned session that looks at what went wrong and why the project failed—like a medical postmortem. Why don’t we do that up front? Before a project starts, we should say, “We’re looking in a crystal ball, and this project has failed; it’s a fiasco. Now, everybody, take two minutes and write down all the reasons why you think the project failed.”

The logic is that instead of showing people that you are smart because you can come up with a good plan, you show you’re smart by thinking of insightful reasons why this project might go south. If you make it part of your corporate culture, then you create an interesting competition: “I want to come up with some possible problem that other people haven’t even thought of.” The whole dynamic changes from trying to avoid anything that might disrupt harmony to trying to surface potential problems.

Daniel Kahneman: The premortem is a great idea. I mentioned it at Davos—giving full credit to Gary—and the chairman of a large corporation said it was worth coming to Davos for. The beauty of the premortem is that it is very easy to do. My guess is that, in general, doing a premortem on a plan that is about to be adopted won’t cause it to be abandoned. But it will probably be tweaked in ways that everybody will recognize as beneficial. So the premortem is a low-cost, high-payoff kind of thing.

The Quarterly: It sounds like you agree on the benefits of the premortem and in your thinking about leadership. Where don’t you see eye to eye?

Daniel Kahneman: I like checklists as a solution; Gary doesn’t.

Gary Klein: I’m not an opponent of checklists for high-validity environments with repetitive tasks. I don’t want my pilot forgetting to fill out the pretakeoff checklist! But I’m less enthusiastic about checklists when you move into environments that are more complex and ambiguous, because that’s where you need expertise. Checklists are about if/then statements. The checklist tells you the “then” but you need expertise to determine the “if”—has the condition been satisfied? In a dynamic, ambiguous environment, this requires judgment, and it’s hard to put that into checklists.

Daniel Kahneman: I disagree. In situations where you don’t have high validity, that’s where you need checklists the most. The checklist doesn’t guarantee that you won’t make errors when the situation is uncertain. But it may prevent you from being overconfident. I view that as a good thing.

The problem is that people don’t really like checklists; there’s resistance to them. So you have to turn them into a standard operating procedure—for example, at the stage of due diligence, when board members go through a checklist before they approve a decision. A checklist like that would be about process, not content. I don’t think you can have checklists and quality control all over the place, but in a few strategic environments, I think they are worth trying.

The Quarterly: What should be on a checklist when an executive is making an important strategic decision?

Daniel Kahneman: I would ask about the quality and independence of information. Is it coming from multiple sources or just one source that’s being regurgitated in different ways? Is there a possibility of group-think? Does the leader have an opinion that seems to be influencing others? I would ask where every number comes from and would try to postpone the achievement of group consensus. Fragmenting problems and keeping judgments independent helps decorrelate errors of judgment.

The Quarterly: Could you explain what you mean by “correlated errors”?

Daniel Kahneman: Sure. There’s a classic experiment where you ask people to estimate how many coins there are in a transparent jar. When people do that independently, the accuracy of the judgment rises with the number of estimates, when they are averaged. But if people hear each other make estimates, the first one influences the second, which influences the third, and so on. That’s what I call a correlated error.

Frankly, I’m surprised that when you have a reasonably well-informed group—say, they have read all the background materials—that it isn’t more common to begin by having everyone write their conclusions on a slip of paper. If you don’t do that, the discussion will create an enormous amount of conformity that reduces the quality of the judgment.

The Quarterly: Beyond checklists, do you disagree in other important ways?

Gary Klein: Danny and I aren’t lined up on whether there’s more to be gained by listening to intuitions or by stifling them until you have a chance to get all the information. Performance depends on having important insights as well as avoiding errors. But sometimes, I believe, the techniques you use to reduce the chance of error can get in the way of gaining insights.

Daniel Kahneman: My advice would be to try to postpone intuition as much as possible. Take the example of an acquisition. Ultimately, you are going to end up with a number—what the target company will cost you. If you get to specific numbers too early, you will anchor on those numbers, and they’ll get much more weight than they actually deserve. You do as much homework as possible beforehand so that the intuition is as informed as it can be.

The Quarterly: What is the best point in the decision process for an intervention that aims to eliminate bias?

Daniel Kahneman: It’s when you decide what information needs to be collected. That’s an absolutely critical step. If you’re starting with a hypothesis and planning to collect information, make sure that the process is systematic and the information high quality. This should take place fairly early.

Gary Klein: I don’t think executives are saying, “I have my hypothesis and I’m looking only for data that will support it.” I think the process is rather that people make quick judgments about what’s happening, which allows them to determine what information is relevant. Otherwise, they get into an information overload mode. Rather than seeking confirmation, they’re using the frames that come from their experience to guide their search. Of course, it’s easy for people to lose track of how much they’ve explained away. So one possibility is to try to surface this for them—to show them the list of things that they’ve explained away.

Daniel Kahneman: I’d add that hypothesis testing can be completely contaminated if the organization knows the answer that the leader wants to get. You want to create the possibility that people can discover that an idea is a lousy one early in the game, before the whole machinery is committed to it.

The Quarterly: How optimistic are you that individuals can debias themselves?

Daniel Kahneman: I’m really not optimistic. Most decision makers will trust their own intuitions because they think they see the situation clearly. It’s a special exercise to question your own intuitions. I think that almost the only way to learn how to debias yourself is to learn to critique other people. I call that “educating gossip.” If we could elevate the gossip about decision making by introducing terms such as “anchoring,” from the study of errors, into the language of organizations, people could talk about other people’s mistakes in a more refined way.

The Quarterly: Do you think corporate leaders want to generate that type of gossip? How do they typically react to your ideas?

Daniel Kahneman: The reaction is always the same—they are very interested, but unless they invited you specifically because they wanted to do something, they don’t want to apply anything. Except for the premortem. People just love the premortem.

The Quarterly: Why do you think leaders are hesitant to act on your ideas?

Daniel Kahneman: That’s easy. Leaders know that any procedure they put in place is going to cause their judgment to be questioned. And whether they’re fully aware of it or not, they’re really not in the market to have their decisions and choices questioned.

The Quarterly: Yet senior executives want to make good decisions. Do you have any final words of wisdom for them in that quest?

Daniel Kahneman: My single piece of advice would be to improve the quality of meetings—that seems pretty strategic to improving the quality of decision making. People spend a lot of time in meetings. You want meetings to be short. People should have a lot of information, and you want to decorrelate errors.

Gary Klein: What concerns me is the tendency to marginalize people who disagree with you at meetings. There’s too much intolerance for challenge. As a leader, you can say the right things—for instance, everybody should share their opinions. But people are too smart to do that, because it’s risky. So when people raise an idea that doesn’t make sense to you as a leader, rather than ask what’s wrong with them, you should be curious about why they’re taking the position. Curiosity is a counterforce for contempt when people are making unpopular statements.

https://www.mckinseyquarterly.com/Strategy/Strategic_Thinking/Strategic_decisions_When_can_you_trust_your_gut_2557?gp=1