Downward Counterfactuals

by F.

A common decision point businesspeople face is, “Merger? Or no merger?”

Invariably, there is second guessing no matter what happens. If the company doesn’t merge, some consultant will say, “Well, if only they had merged, they’d have a more diversified product portfolio and could spread the risk of their various product bets across more offerings.” If they did merge, the same consultant will say, “Well, if they hadn’t taken on all that debt to do that merger, they’d be in much better shape.” And so on.

Now a little daylight may get shed on this problem. Dennis Berman in the WSJ describes

a new study by a young professor at the University of Pennsylvania’s Wharton School, Pavel Savor, [that] develops a crude but intriguing method for assessing those unchosen paths.

He slogged through thousands of mergers between 1990 and 2000, sifting for deals that fell apart before closing because of regulatory disapproval, competing offers and others reasons. The group of 56 transactions he came up with represented, in essence, an alternate M&A reality, isolating companies intent to do deals, but failing to follow through. “My paper is all about disentangling what would have happened anyway,” he said.

Dr. Savor found that for stock-only deals, companies that failed to complete transactions were punished by investors. Three years after their deals died, the acquiring companies outperformed the nonacquirers by a stark 27% in the stock market.

Here’s the interesting bit:

The CEOs are a part of something that is of growing fascination to psychologists, economists and the occasional science-fiction author. The tweedy types use a term called “downward counterfactuals,” which describes when one believes his current fate is better than some other path he could have taken and managed to avoid.

It turns out people just aren’t programmed that way. (That’s especially true when it comes to investing.)

In the excellent book “The Paradox of Choice,” author Barry Schwartz brings up the proverbial silver medalist. Instead of being happy she avoided missteps that would have earned a bronze, she is likely to regret the flubs that kept her from winning the gold.

Research shows that people rarely focus on the problems they’ve managed to avoid, unless specifically asked to do so, Mr. Schwartz writes.

The take away is that, when we choose the “least worst option,” we may focus on the “upward counterfactual”—the dream scenario in which the merger brought huge gains—rather than the “downward counterfactual”—the sucky option that we didn’t take but that would have been worse. Sometimes the least worst option is the best option.

Of course, if you’re a CEO, you can’t say this to investors;

“The market cannot deal with hypotheticals like that,” [the CEO of Boston Scientific] said. “They look at earnings.”