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From McCombs Today

The Wall Street Journal, October 20, 2009

A recent column in the Wall Street Journal, headlined “When Bad Luck is a Crime,” uses research coauthored by Andrew Henderson (right), associate professor of management.

Excerpt: When it comes to cheering CEOs, booing them or throwing them in jail, a consideration that ought to be nagging is whether we’re reacting to luck or design. Ken Lay, to cite a notorious example, was prosecuted not for the sins that brought down Enron, but for failing to tell investors the company was predestined to fail even as he tried to save it….

How much more fun, when dealing with circumstances like these, to play the after-the-fact-know-it-all, naming heroes and villains with the confidence afforded by the rear-view mirror. Bad enough is when journalists give unreflective vent to this urge, but unhealthy for society is when prosecutors do it.

For a bracing dose of perspective, consider the flip side question. An eye-opening new paper asks: With so many public companies to choose from, how do we know the good firms from the merely lucky ones? The question is a much harder call than you might think.

The authors—Andrew D. Henderson of the University of Texas at Austin, and Deloitte Consulting’s Mumtaz Ahmed and Michael E. Raynor—begin with a caveat no less applicable to the joyous media blame-laying after the subprime debacle: “If you have a large number of players in a game in which luck plays a major role, then some players will assemble seemingly impressive winning records by chance alone.”

“Luck,” they add, “can mislead us . . . because humans tend to mistakenly perceive patterns in random data.”

By way of analogy, imagine a classroom of 70 students, each of whom is asked to flip a coin and sit down if tails comes up. According to the law of probabilities, after seven flips a single student should be standing—the one who flipped heads seven times in a row. If the student were a company, the authors say, he’d quickly become a case study of “excellence” in coin flipping.

Messrs. Henderson, Ahmed and Raynor, who presented their work at the Academy of Management’s annual meeting in Chicago in August, weren’t just indulging an urge to philosophize. Their goal was to design criteria for identifying excellent firms while cutting the rate of “false positives” to approximately one in 10.

It turns out the criteria are exceedingly stringent. Over a period of 10 years, a firm must score among the top 10% of performers at least nine times. Only 150 firms in a database of more than 21,000 make the grade—including Microsoft, Tambrands and Landauer Inc. (a manufacturer of radiation dosimeters).

Remember, the goal here is to create a list of “excellent” firms only 10% of which owe their ranking to luck. It still doesn’t tell you which were the lucky ones. Here, journalism, and perhaps only journalism, can unpack the final puzzle—albeit a journalism that properly understands the role of luck in determining the outcomes that so excite journalists and sometimes prosecutors in the first place. Read story in the Wall Street Journal.