Ideas to Action by Darden School of Business

SPRING 2014

FACULTY RESEARCH FROM THE UNIVERSITY OF VIRGINIA DARDEN SCHOOL OF BUSINESS

THE PROFITABLE PROMISE OF DESIGN THINKING with Jeanne Liedtka

INSIDE Divining the Future Through More Accurate Forecasting

Business Is a Good Thing

China’s Delicate Balancing Act

Embracing the Weird

Watch Out for Fairy Tale Returns

The Who and How of Wooing Customers

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A CRADLE OF INNOVATION At the University of Virginia Darden School of Business, we focus on the challenges executives around the globe face every day in the business world. We seek to offer forwardthinking business leaders ideas they can immediately put into action in the workplace. To generate those ideas, we nurture a vibrant research ecosystem within Darden, which is the graduate business school of the public university founded by Thomas Jefferson in 1819. When Jefferson built the University — which he considered his “greatest accomplishment” — nearly 200 years ago, he established a cradle of innovation, which flourishes today. At Darden, our mission is to develop responsible leaders and to advance business knowledge. We want to shape the way people work in the 21st century by equipping them with the fresh ideas and new skills they need to operate in our global, fast-changing world. This new biannual publication, Ideas to Action — along with the corresponding website and video series — introduces you to some of the Darden School of Business’ thought leaders and their ideas. This inaugural issue highlights the work of professors who are breaking ground in the fields of marketing, business ethics, decision analysis, global markets, finance, innovation and growth, and leadership. For example, Professor Jeanne Liedtka shares her new approach to solving business problems and spurring innovation through design thinking, and Professor Ed Freeman explains why business is a force for social good. The ideas presented in these pages are culled from books, research papers and Darden Business Publishing case studies, and include insights from the School’s 10 research Centers of Excellence. Creating new ideas requires collaboration, and we welcome yours. What do you see as the next most pressing business challenge?

S. Venkataraman Senior Associate Dean for Faculty and Research MasterCard Professor of Business Administration venkats@darden.virginia.edu

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TABLE OF CONTENTS 4

DIVINING THE FUTURE THROUGH MORE ACCURATE FORECASTING

BUSINESS IS A GOOD THING

CHINA’S DELICATE BALANCING ACT

EMBRACING THE WEIRD

THE PROFITABLE PROMISE OF DESIGN THINKING

WATCH OUT FOR FAIRY TALE RETURNS

THE WHO AND HOW OF WOOING CUSTOMERS

4 DARDEN IDEAS TO ACTION

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DECISION ANALYSIS

DIVINING THE FUTURE THROUGH MORE ACCURATE FORECASTING Two Darden School of Business professors are tinkering with an innovative way of combining and refining forecasts — a kind of crystal ball refurbishing — that will better divine the future.

6 DARDEN IDEAS TO ACTION

Yael Grushka-Cockayne and Casey Lichtendahl have developed a method to sharpen forecasts critical to businesses or economists, such as company sales or profits, GDP growth or inflation rates. They propose a new way to combine individual probability forecasts. The combined forecast offers improved accuracy by trimming the pool of opinions collected. “We want to refine our crystal ball to get a better sense of what’s in the future and make sure our decisions are better,” says Grushka-Cockayne, an expert in the area of decision analysis and behavioral decision-making. “We want to get better forecasts because at the end of the day that could lead to higher profits.” “The big idea is that we can better tap into the wisdom of the crowd,” she says. “We want a range for our forecasts, and we look at ways to combine these distributional forecasts and look at how to average them in more sophisticated ways.” “And that does things you want,” says Lichtendahl, also an expert in decision analysis and in probability forecasting and combining forecasts. “It does very interesting stuff.” Trimming is a well-known averaging method used to reduce the effect of outlying data. Most companies use single-point estimates typically based on an average of expected data. What smart forecasters know is that a single-point forecast will almost always be wrong because forecasting a single number is close to impossible. “With point forecasting, you’re always wrong,” says Lichtendahl. “You’re always above or below.”

The two professors come at combining forecasts and trimming differently. “We assume the forecasters don’t give us a single number. They give us a range or a probability,” says Grushka-Cockayne. “Think of typical trimming as being done in a single dimension. We’re extending that to something that has two dimensions, such as those ranges of numbers or probabilities. So we’re taking trimming and applying it to more dimensions.” Lichtendahl says their pioneering method uses both exterior and interior trimming to better weigh a range of future possibilities that will, in turn, more accurately reflect the truth. Exterior trimming removes the forecasts with low and high averages before calculating the pool’s average. Exterior trimming decreases the pool’s variance and improves its calibration. Interior trimming takes away forecasts with moderate means, or cumulative distribution function values. “We had to invent the idea to interior trim,” he says. “We were able to relate exterior and interior trimming to overconfidence and underconfidence.” Two examples illustrate the use of multidimensional trimming as it relates to confidence. The professors found that economists, for instance, those

THE BIG IDEA IS THAT WE CAN BETTER TAP INTO THE WISDOM OF THE CROWD.

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submitting forecasts to the Fed’s Survey of Professional Forecasters, are underconfident in forecasting inflation rates — perhaps because inflation is so variable — and so exterior trimming of probabilities is necessary to hone the forecast. “You get rid of the extremes, which then might reflect better the view of the group, rather than let the view of the group be pulled in a direction by the guy who has the wildest view,” Lichtendahl says. The opposite problem occurs when forecasters take a shot at predicting GDP growth, for example. They tend to be overconfident, are too narrow in their forecasts and could miss some important event. “Those people in the middle are saying the same thing over and over,” says Lichtendahl. “Our trimming method will help you balance overconfidence and underconfidence,” says Grushka-Cockayne. They’ve extended this method into the machine learning environment. Machine learning technology has become faster in handling big data. Machines can spit out hundreds of model predictions — think of each as an expert’s opinion — also known as weak learners. “Each is weak because it’s narrow,” says Grushka-Cockayne. “But when we average across them … we improve by trimming the probability forecast.” How big is the improvement? The professors have tested their method in theory. They found that, for example, in the case of predicting diamond prices, they improved the forecast by 3.3 percent. In predicting GDP growth, the improvement came in at a whopping 18.5 percent. “This is an evolving thing,” says Lichtendahl. “We want to start using it in the real world to see how much economic gain there is. There are statistical improvements that we can demonstrate, but economic gains are going to come from in-use experience.” Grushka-Cockayne says that other researchers “have tried to find better ways to combine. It’s a known problem and one that is interesting to many people. What I like about trimming is it’s very straightforward to execute.” The two professors are currently writing a trimmed opinion pool algorithm for R — an opensource software program for statistical computation

THIS IS AN EVOLVING THING. WE WANT TO START USING IT IN THE REAL WORLD TO SEE HOW MUCH ECONOMIC GAIN THERE IS. THERE ARE STATISTICAL IMPROVEMENTS THAT WE CAN DEMONSTRATE, BUT ECONOMIC GAINS ARE GOING TO COME FROM IN-USE EXPERIENCE. and graphics — “so that somebody can take a data set into this environment and very quickly get out a trimmed probability forecast,” says Lichtendahl. The next step is to tell the business world, which is still loyal to point forecasting, about their method. “Now that we have results and have already coded the method completely in the software package, and we know how to optimize it — how to make it work beyond the theoretical mathematics — we’re basically broadcasting it,” says Grushka-Cockayne.”We’re trying to get more people aware of it.” “This is a long journey,” says Lichtendahl. “It’s going to take us many years.”

Yael Grushka-Cockayne, assistant professor of business administration at Darden, and Kenneth C. Lichtendahl Jr., associate professor of business administration at Darden, co-authored with Victor Richmond R. Jose the paper “Trimmed Opinion Pools and the Crowd’s Calibration Problem,” published in Management Science (Volume 60, Issue 2, February 2014).

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8 DARDEN IDEAS TO ACTION

BUSINESS ETHICS

BUSINESS IS A GOOD THING Is business a black art of guile and greed? Is the only purpose of business to make the maximum profit possible? Is business ethics impossible, an oxymoron and a bad joke?

No, no and no — a drumbeat of answers that Darden School of Business Professor R. Edward Freeman has known for decades from his work on “Stakeholder Theory” and as an irrepressible optimist in the ability of business to solve the world’s problems. “The story about business is that business people are bad and what they do is morally questionable,” says Freeman, a philosopher by training. “But for every Enron, there are 10,000 good companies. Most companies are trying to do the right thing. Most people are trying to do the right thing.”

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Freeman, at least anecdotally, has seen a growing cultural shift in the perception of business. “I have been an observer of business for more than three decades, and I can tell things are changing. There have been thousands of new businesses started that have tried to make the world a better place and, most importantly, add real value to our daily lives.”

The Stakeholder Theory Freeman wants to change the story about business. “I’m trying to recast the very way we think about

business,” he says, especially in the aftermath of the global financial crisis, in which the old model of business — profit maximization — contributed to the meltdown. Stakeholder Theory argues that stakeholders come first — whether it’s shareholders, employees, customers or the community. His seminal book Strategic Management: A Stakeholder Approach, originally published in 1984, identifies those stakeholders and how to include them. In 2010, Freeman and his colleagues published Stakeholder Theory: The State of the Art, which summarizes the accumulated body of research and makes the case that business is about creating value for the stakeholder. Freeman challenges businesses to look beyond profits. “The old way of business presupposes the purpose of business is to make profits,” says Freeman. “This is akin to believing that making red blood cells or breathing is the purpose of life. Yes, we must have red blood cells, just as businesses must make profits. But the purpose of business is usually determined by a passionate entrepreneur chasing a dream to change the world.” One of those people chasing a dream is John Mackey, co-CEO of Whole Foods Market. Freeman cites him as an example of the new order, of those great business leaders who practice conscious capitalism. In an interview with Freeman, Mackey said that entrepreneurs — though they want to make money — start businesses out of passion. Mackey went on to say that physicians make money, but their mission is to heal; teachers make money, but their desire is to educate; and architects make money, but they yearn to build. The question, Mackey noted, is: Why the myth that businessmen only want to make money? Other examples of passionate people chasing a dream? The Motley Fool’s main mission, says its CEO Tom Gardner, is to help people become better investors. Kip Tindell, CEO of The Container Store, explains that taking good care of their 6,000 employees leads those employees to take very good care of customers and other stakeholders. The result is profit. “Shareholder value is the outcome,” says Freeman.

Putting Purpose Back Into Capitalism Capitalism has always had its share of critics, who claim it leaves scandal, pollution and poverty in its wake. “Capitalism may not be perfect,” says Freeman. “Yet it is the greatest system of social cooperation

THE PURPOSE OF BUSINESS IS USUALLY DETERMINED BY A PASSIONATE ENTREPRENEUR CHASING A DREAM TO CHANGE THE WORLD. created thus far. Capitalism works because entrepreneurs and managers figure out how customers, employees, suppliers, communities and people with the money all can cooperate to mutual benefit. Competition is important, but it is a second-order property that gives people more choice in a free society.” Business is a deeply human institution, says Freeman, and its purpose is not to make as much money as possible. “The purpose is something else. We need to put purpose back into capitalism.” In fact, Freeman says business is “primarily about purpose — money and profits follow. Any business creates (or sometimes destroys) value for shareholders, as well as customers, employees, suppliers and communities. Building and leading a business involves getting these interests going in the same direction.” Business and ethics go hand in hand, says Freeman. “Sometimes we act for selfish reasons and sometimes for other-regarding interests. Incentives are important, but so are values. Most people tell the truth and keep their promises and act responsibly most of the time. And we need to encourage that behavior. When these expectations are not met, it is not just bad ethics, it is also bad business. Business and ethics go together.” And while there are real benefits to the standard story about business — it has lifted billions out of poverty — it can be made better by applying one of its basic principles, says Freeman. “Critique by creating something better. If you think that too many executives just focus on profits and money, then start a business that focuses on a purpose more than profits and relies on the passion of its employees.”

R. Edward Freeman, Elis and Signe Olsson Professor of Business Administration at Darden, is the author of Strategic Management: A Stakeholder Approach (Cambridge University Press, 2010); Managing for Stakeholders: Survival, Reputation and Success (co-authored with Jeffrey S. Harrison and Darden Professor Andrew C. Wicks, Yale University Press, 2007); and Stakeholder Theory: The State of the Art (co-authored with Jeffrey S. Harrison, Darden Professors Andrew C. Wicks and Bidhan L. Parmar, and Simone de Colle, Cambridge University Press, 2010).

SPRING 2014

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GLOBAL MARKETS

CHINA’S DELICATE BALANCING ACT Darden Professor Dennis Yang, an expert on the global economy, seeks to solve one of the world’s more curious economic conundrums: the Chinese savings puzzle.

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12 DARDEN IDEAS TO ACTION

China’s extraordinary savings and investment rates have created an economic imbalance, which has implications for the world economy and the country. Yang says China needs structural reforms. Yang has personally witnessed how powerful economic reforms can be. He grew up during the Chinese Cultural Revolution, which began in 1966 and ended in 1976 and was led by Chairman Mao Zedong. The revolutionaries forced many of the educated classes, including Yang’s family, to be re-educated at countryside camps — a punishment called rustication. Yang’s family eventually returned safely to Beijing. After Mao’s death in 1976, China transitioned toward a market-based economy, though still a single-party state. Yang — who would go on to study in Italy and America and receive his Ph.D. in economics from the University of Chicago — has researched the evolution of China’s savings rate. During the 1980s and 1990s, China’s healthy savings rate stood at about 35 to 40 percent of GDP. In 2001, China joined the World Trade Organization, kicking off the country’s “golden period of growth,” and transforming China into the workshop of the world, says Yang. However, macroeconomic imbalances grew with the phenomenal economic expansion and profits. With China reaching an astonishing aggregate savings rate of 53 percent of GDP by 2008, it also experienced a corresponding sharp rise in the surplus of its current account balance. The savings rate includes savings by households, the government and companies in the form of retained earnings. By comparison, the world’s average aggregate savings rate is 20 percent. The U.S. aggregate savings rate in 2008 was 13 percent. Government and corporate sectors accrued much of the savings increase because of China’s policies favoring exports and businesses in general, says Yang.

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Firms thrived thanks to low wages paid to workers pouring into cities from rural China seeking jobs, and by “distortional policies,” such as low interest rates for borrowing by large state enterprises that kept the cost of production low. China also bestowed tax rebates on exporting companies that were as high as 17 percent of their export value. “The strong incentive to sell abroad makes many China-made goods cheaper in the U.S. than in China.” The government, while collecting increasing amounts of taxes and social security payments, and though investing in roads and other basic infrastructure projects, didn’t proportionately increase its spending on education, health and other social welfare programs. That raised government savings, left a lower share of GDP in the hands of the households and forced households to save more money out of precaution. These are the underlying forces behind “weak domestic consumption and an anemic demand for imported goods,” says Yang. “There is a phrase in China — rich nation, poor people.” When China experienced “the twin surpluses in trade and financial account, where foreign direct investment inflow was a large component, the result was an upsurge in foreign exchange reserve in recent years.” China invested in other countries in instruments such as U.S. Treasury bonds or Eurobonds or even in foreign companies — such as Virginia’s Smithfield Foods, bought by a Chinese firm for $4.7 billion last year. “These imbalances are undesirable for the global economy and for China because the holding of excessive foreign reserves is risky since their value is dependent on monetary policies or the changing circumstances of foreign countries,” Yang says. “Returns to these reserve assets are also low.” Moreover, China also faces political pressure from major trading partners — such as the U.S. — who blame its large trade deficit for further weakening their economies. “Mounting pressure exists for China to rebalance its economy,” says Yang, which in part requires the redistribution of income towards the household sector — in order to raise aggregate consumption. Consumption in China tops out at 50 percent of GDP — the lowest fraction of GDP recorded in any major economy. Though an aging population and slower economic growth are already lowering the national savings rate, Yang says China, with a population of 1.3 billion people, should also spend more money on educa-

tion, its health care system, pensions and social security — “especially for its vast rural population.” The result will be less of the population holding onto “precautionary savings.” “China should establish efficient institutions to assure appropriate earnings for the household, protect the basic rights of workers and enforce the employment contract law,” he says. In the past five years, China has raised minimum wages for blue collar workers by 10 to 15 percent each year. “Despite concerns over whether minimum wage is an efficient measure for income redistribution, the rise in the income of the poor will stimulate consumption internally and have important implications for businesses.” In addition to wage growth, land value and housing prices have gone up significantly in the past 10 years, “raising the general cost of manufacturing and reducing the profitability of businesses,” he says. “When China’s labor becomes more expensive, there will be a reallocation of business to locations with cheap labor, possibly to countries like Vietnam and Indonesia; at the same time, Chinese workers are richer and can contribute to the rebalancing of the Chinese economy.” Meanwhile, the Chinese government appears eager to improve the productive capacity of its workforce and to spur innovation-driven growth, says Yang. “China needs to invest more in education and the right kind of infrastructure for innovation. So far, public investment in education and training as a share of GDP has been below the average of developing countries.” “I think it’s time for China to reconsider its overemphasis on exports as a source of economic growth and reconsider export tax rebates. It should also gradually remove special privileges given to companies in special economic zones.” Yang says the “mammoth current account surplus in recent years … was by and large not intended or desired by China.” Policymakers simply failed to understand the complexities causing the economic imbalances that were further compounded by past policies favoring the government and production over welfare of the people of China. Yang says, “In this sense, China is both the culprit and victim of its own macroeconomic imbalances.”

I THINK IT’S TIME FOR CHINA TO RECONSIDER ITS OVEREMPHASIS ON EXPORTS AS A SOURCE OF ECONOMIC GROWTH AND RECONSIDER EXPORT TAX REBATES. IT SHOULD ALSO GRADUALLY REMOVE SPECIAL PRIVILEGES GIVEN TO COMPANIES IN SPECIAL ECONOMIC ZONES. Dennis Yang, Dale S. Coenen Free Enterprise Professor of Business Administration at Darden, is co-editor of the book Has China Passed the Lewisian Turning Point? with co-editors Cai Fang and Huang Yiping (Social Sciences Academic Press; Beijing, China; 2012; in Chinese).

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LEADERSHIP AND ORGANIZATIONAL BEHAVIOR

EMBRACING THE WEIRD

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Martin Davidson has widened even his own broad definition of diversity to include perhaps the most different of all people — the weird. That’s right. The weird. The different. The strange. The offbeat. The people who don’t fit in. Even — maybe — you. Davidson, a Darden School of Business professor well-known for his work on leveraging difference, says there is power in being so different that many would call you weird. “I’m fascinated by the kind of weirdness that moves us forward and allows something new and innovative to emerge,” says Davidson. He’s writing a book with the working title Embrace the Weird. The book will explore how people who don’t fit in at work can offer different ideas that will help businesses thrive. He believes nurturing the weird is actually necessary to encourage new ideas. “The key for leaders is to figure out how to develop weird people so that they create — not destroy — value for the company.” Davidson wants to explore ways to support those who have stifled their offbeat creativity out of social fear. “How do we structure organizations so that people can be more themselves? How do we help these people strengthen themselves? How do we create an environment so they can express different ideas instead of shutting them down?” Davidson says most of us avoid people we consider too weird. And some weird people resort to hiding — camouflaging themselves as normal. “All of us have elements of weird, but we tend to keep them under wraps,” he says. “Some weird people think it’s not appropriate to be themselves at work. They leave themselves at the door.” Though he’s in the early stages of his research, he knows that weird people often struggle as a result of their weirdness. “Being weird is hard. I hear these stories of pain, of not fitting in a social world. But it doesn’t mean that all weird people are unhappy. I’m intrigued by what turns the struggle into positive energy and productivity.” Davidson differentiates between two types of weirdness. One involves people who act weird just to oppose the norm. He calls that the “little w” in weird. “Little w weird is all about ‘me.’ It makes you feel good to feel different, but you’re not contributing what you could, what is really needed. These weird people often have voracious egos.” In contrast, “big W weird people oppose the norm but not just for the sake of standing out,” says Davidson. “Rather, they are trying to see something or achieve a larger goal, and they know following a normal path won’t get you there. Often these folks are more humble than their ‘little w’

weird brethren; they are just focused on getting a great result.” Davidson is known for his groundbreaking work in highlighting the power inherent in people who are different. Davidson wrote the provocative book The End of Diversity as We Know It: Why Diversity Efforts Fail and How Leveraging Difference Can Succeed. In the book, he urges leaders to hire people who embody differences that are most important to the company’s goals. Those differences include subtle ones, such as personality and thought — not just noticeable differences, such as race, gender or culture. Instead of seeing diversity as a distracting mandate handed down from HR, Davidson focuses on how leaders can use difference to create a competitive advantage for their firms. Researching those who are weird dovetails with his work on how leaders can leverage the difference in people to create value. “Weirdness is an underappreciated but important ingredient in leveraging difference,” he says. “We want to take from the margin to rethink the whole.” Companies are always searching for innovations, for ways to grow, he says, and “that’s why weirdness is important. Weird people could be our greatest resource.”

ALL OF US HAVE ELEMENTS OF WEIRD, BUT WE TEND TO KEEP THEM UNDER WRAPS. But there’s much more to learn. One of his key research questions is why some people who stand out as weird nevertheless thrive at a business. He’s conducting interviews at a variety of organizations in different industries. “Embrace the weird,” Davidson urges. “They are the people who will help you grow. We can learn a lot from weirdness and weird people. We can learn how those of us who struggle to stand out and be noticed can do so more effectively. You have to admit that productively weird people are experts at this.”

Martin Davidson, professor of business administration at Darden, is author of the book The End of Diversity as We Know It: Why Diversity Efforts Fail and How Leveraging Difference Can Succeed (BK Business, 2011).

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DESIGN THINKING

THE PROFITABLE PROMISE OF DESIGN THINKING

Jeanne Liedtka, United Technologies Corporation Professor of Business Administration at Darden, is co-author with Andrew King and Kevin Bennett of the book Solving Problems With Design Thinking: Ten Stories of What Works (Columbia University Press, 2013) and coauthor with Tim Ogilvie of Designing for Growth: A Design Thinking Tool Kit for Managers (Columbia University Press, 2011).

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Jeanne Liedtka believes you’re much more creative than you think. Your workplace may be keeping you down. “Many businesses drive out a lot of creativity,” she says. Big businesses can be the worst offenders, demanding a level of predictability and efficiency that is good for today’s bottom line but bad for tomorrow’s. So managers charged with growing the business must still live and die by traditional data, by ROI and by only a dutiful nod to the customer, who is often seen primarily as a sales target. The pressure to grow is relentless, but the battle is often uninspired. Liedtka, a U.Va. Darden School of Business professor, teaches an unusual way of thinking that can spur inspiration and innovation even in the stiffest of workplaces. Dubbed “design thinking,” it’s simply a different approach to problem solving. “It’s really very helpful in becoming creative,” she says. “It brings tools

and processes. Creativity is not as random as you think.” In fact, design thinking dispels what Liedtka calls the “Moses Myth” — the belief that only a special person can part the seas and create. Design thinking arms even the most traditional thinker, even the dullest among us, with ways to exercise creativity.

An Alternate Path to Creativity The 10 tools she uses vary from visualization — the use of imagery to see possible future conditions — to journey mapping, which is assessing things through the eyes of a customer. Liedtka has just written a book titled Solving Problems With Design Thinking: Ten Stories of What Works, as well as a field guide to accompany her book Designing for Growth: A Design Thinking Tool Kit for Managers. “Design thinking offers an alternate path,” she says. That alternate path leads to creativity, and that creativity leads to simple but game-changing ideas, such as suitcases with wheels and easy-topour, upside-down ketchup bottles. “Most managers are taught a linear problem-solving methodology: Define the problem, identify various solutions, analyze each and choose the best one,” Liedtka says. “Designers aren’t nearly so impatient — or optimistic. They understand that successful invention takes experimentation and that empathy is hard-won.” Embracing design thinking means understanding that the customer is a real person with real problems, rather than a sales target. Instead of traditional market-research data, design thinkers dig for data that is “user-driven and offers a deep understanding of a customer’s unarticulated needs,” says Liedtka. Design thinking helps reframe questions in a way “that expands the boundaries of the search itself,” she says. Unearthing unarticulated needs must be done before solutions are even contemplated. Or as Steve Jobs famously put it: “It’s really hard to design products by focus groups. A lot of times, people don’t know what they want until you show it to them.”

Structured Brainstorming Design thinking requires taking a hard look at the present, “drilling down to the essence of an issue to see what really matters,” she says. Researchers at Procter & Gamble were focused on improving detergents used to clean floors. That focus was limiting. Design thinking pointed them to a better answer — customers wanted cleaner floors — and a better mop could better solve that problem. So was born the best-selling Swiffer. One of the keys to conjuring up a product like the Swiffer is brainstorming, though not the traditional kind. Liedtka calls it “structured brainstorming,” which uses the data collected during the discovery phase as input, then converts the brainstorming output into something valuable — concepts of new

THE KIND OF STRUCTURED BRAINSTORMING APPROACHES THAT DESIGNERS USE ARE FAR MORE PRODUCTIVE THAN THE FREE-FORM SHOUT-OUT THAT WE’VE ALL ENDURED IN THE PAST. possibilities. “The kind of structured brainstorming approaches that designers use are far more productive than the free-form shout-out that we’ve all endured in the past,” she says. The ideas can be so plentiful that one firm Liedtka recently worked with “generated more than 300, which they narrowed down to 23. Of these, only five eventually made it to marketplace testing.” Design thinking works to make marketplace testing practical, “engaging customers in the act of building a new product. You need to create as vivid an experience as possible. You’re engaging the customer to get at their needs. It’s not a dress rehearsal,” says Liedtka.

Fail Early and Succeed Sooner Unlike traditional marketplace thinking, design thinking “expects to get it wrong,” she says. “You experiment and figure out why it works or not. The goal is to fail early to succeed sooner. Actively look for data that proves the product won’t work. It’s valuable information for saving money and zeroing in on how to make the product work.” In a nutshell, design thinking “is just another approach to problem solving, an especially effective one if your goal is innovation,” she says. “These tools emphasize attention to developing deep user-driven insights as the basis for envisioning new possibilities, engaging a broader group of stakeholders in co-creation, and then prototyping hypothesized solutions and testing these in small-scale experiments.” Design thinking is also a powerful method to help solve what are known as “wicked problems.” The problems are not wicked in the sense that they are evil, but in the sense they are ill-defined — such as health care or poverty or failing schools. “Design thinking can change lives for the better,” says Liedtka.“It’s not just a means to make cool stuff for people with money.”

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18 DARDEN IDEAS TO ACTION

FINANCE

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20 DARDEN IDEAS TO ACTION

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Richard Evans first heard the word “incubation” while a Ph.D. student at the Wharton School. As part of his dissertation, he sought to understand how some mutual funds generated fantastic returns but weren’t open to the public for investing. He called one of the investment management companies running the funds to inquire.

Rich Evans, associate professor of business administration at Darden, received the 2013 Wachovia Award for Research Excellence for “Significant Publication in a Peer-Reviewed, Discipline-Based Journal” for his paper “Mutual Fund Incubation,” published in The Journal of Finance (Volume 65, Issue 4, August 2010).

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The company told him the funds were incubating, an answer that launched a curious graduate student into landmark research that would bring light to a murky corner of the mutual-fund world. In time, Evans discovered that only the highest-performing incubating funds would be open to the public. Their target? The mom and pop investor. The returns? Unbelievable — as in a fairy tale. Evans says the story of how incubating funds work teaches caution to investors. “The best solution to these types of problems is not regulation; rather, it’s to help the investor make good decisions, to teach people the right metrics.” Evans, a Darden School of Business professor whose research deals broadly with investment decisions, says that “retail investors tend to pay more attention to good historical returns.” Past performance, however, doesn’t tell you much at all, a disclaimer that every fund shares with investors. But some investors — especially less sophisticated ones — gravitate to past performance. And so evolved the clever strategy of incubation, in which mutual funds are managed quietly — and in private — for several years, using the money from the fund family itself. “The funds are essentially private because they don’t have tickers and often aren’t reported to Morningstar, CRSP, Lipper or other mutual fund data providers until the fund sponsor is ready to open them to the public,” Evans says. But incubating funds can’t be kept totally secret because in order to use a “track record” to promote a fund, the performance has to be filed with the SEC. That’s where Evans unearthed the information he needed.

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Because the funds are hidden from the general public and the funds are essentially using house money, fund managers can invest in riskier assets and have more concentrated portfolios, increasing the odds that one or two funds will show great returns. Money also doesn’t flow in and out of incubating funds — unlike public funds — simplifying the financial landscape and increasing their odds of higher returns. Eventually the fund managers pluck those few incubated funds with the best returns to offer to the public and “kill off” the many funds which failed to produce good returns. That selective reporting makes the chosen funds look like much better investments than they are, says Evans. “Even if each fund’s performance is random, if you start enough funds, at least one of them will be good,” he says. “You take 10 funds, one is going to hit.” In other words, the fund manager, using incubation, contrives the return. For example, one privately owned investment management firm set up a dozen or so funds to percolate in incubation. The historical returns reached an astonishing 30 percent for one of those funds. Investors mesmerized by the huge return flocked to the heavily publicized fund without understanding it was incubated, says Evans. The fund’s overall performance, once in public, was mediocre. But investors stuffed the fund with over $2 billion in assets. “Funds in incubation outperform nonincubated funds by 3.5 percent, risk-adjusted, and when they are opened to the public they attract higher flows,” says Evans. “Post-incubation, however, this outperformance disappears.” Evans did the first major study on mutual fund incubator bias. The study covered a 10-year period from 1996 to 2005. In summary, he found:

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• Managers incubated almost 25 percent of new funds. • Incubated funds attracted higher net-dollar flows, as the public believed these were superior funds. • The outperformance disappeared post-incubation. • The performance reversal imparted an upward bias to returns that was difficult to correct. • The bias resulted in risk-adjusted alphas being overstated by 0.84 percent on an equal-weighted basis. “The bottom line is that many fund families are creating fairy tales to intentionally mislead investors,” he says. “While most funds’ prospectus disclosures include a statement that past performance is not related to future performance, for incubated funds past performance is related to future performance … negatively related. On average, incubated funds underperform their prior track record once they are opened to the investing public.” But since his eye-opening findings, Evans found that some fund managers using incubation strategy have shifted to hedge funds or private investment vehicles. So what is a smart investor to do? Stay away from funds that show a big jump in assets. That could mean the fund just emerged from incubation, he says. Evans also cautioned against about chasing past performance. “You’ll be better off buying an index fund. Keep a broadly diversified portfolio. Balance it on occasion.” “It may be a boring way to invest, but it works.”

SPRING 2014

22 DARDEN IDEAS TO ACTION

MARKETING

THE WHO AND HOW OF WOOING CUSTOMERS Darden Professor Rajkumar Venkatesan’s ultimate goal is to find profitable customers. He seeks to determine the behavior of customers: What do they buy, what are their attitudes and what might they buy?

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“Think of me as a treasure hunter. I see in the data some clues to the map — it’s about how customers behave. The data gives me some clues. I put the clues together,” says Venkatesan. “I get a partial picture of customer behavior and also motivation, and I use that to project what the customer profit would be, given what I know about how customers react and what their preferences are.” In a nutshell, he has formulated a model to develop customer-centric marketing strategies that provide measurable financial results. His book Cutting-Edge Marketing Analytics: Real-World Cases and Data Sets for Hands-On Learning will be published in July 2014. His co-authors are Darden Professors Paul Farris and Ron Wilcox.

Seeing Customers Across All Dimensions Marketing used to be more art than science, Venkatesan says. But with the advent of point-of-sale scanners and the use of loyalty cards and credit cards, data started pouring in. Firms began using Customer Relationship Management (CRM) tools and technologies to capture what customers bought and when. “Now you can see a customer across all the dimensions, which was not possible before,” says Venkatesan. More firms today are also mining the Internet — Facebook, Twitter, chat rooms and blogs

WHAT I CAN TELL YOU IS THAT USING MY METHODOLOGY MAKES FIRMS DO BETTER THAN THEY ARE DOING RIGHT NOW. I CAN STAND BY THAT STATEMENT. — to “infer people’s attitudes toward their brands,” he says. “It’s not expensive. It’s just technical.” “I played in the CRM space for a long time, and over time I have built this model that measures how much profit a customer provides to a firm,” he says. “What we did was connect that information to marketing activity, which is not just finance and accounting. It’s not just counting the beans. It’s looking at how the beans came about.” That means, for example, looking at how customers are contacted — by phone, e-mail, direct mail, television ads or print ads. “We look at everything a marketer does to link to a customer,” he says. Venkatesan answers two critical questions with his model: Which customers should be targeted, and how should they be targeted? A three-year study he conducted with a big pharmaceutical company — pertaining to sales calls directed toward physicians — showed that firms obtain better predictions of customers’ future profit potential if they include information on customer attitudes in addition to the past customer behavior in their marketing strategy. “So this is what I’ve done conceptually,” he says. “I’ve built a framework that helps people do this. Essentially, you use data, not just math, to spot trends and to project the customer value — the profits.” “So for who to target, you measure the value of a customer. If the customer’s worth $100, don’t spend more than that. For how to target, measure their preferences. Using that, you can build a company strategy.”

Attitude Matters Current marketing strategy recommends that firms should look at customer behavior only — not attitude — because it works on the belief that behavior includes attitude. Venkatesan disagrees. “People behave certain ways because they have some preferences.” “What we found is these things are forward-looking measures; their attitudes give us insight into what happens tomorrow. You have preferences and are going to take some action tomorrow. If I find that out today, I can do something about it. Think of it as early warning indicators.”

The “top” customers’ — on whom companies traditionally focus — and the “bottom” customers’ attitudes are pretty self-evident, he says. “The issue is which of the middle customers become top customers and which become bottom ones.” “Finding out attitude lets you know what those middle customers are going to do because behavior is noisy. It’s up, it’s down. That’s why they’re in the middle. Then you merge attitude and behavior. It makes you better at who to target and how to target,” he says. “It’s better than one or the other.” “I’m implementing mathematics to make companies use their data better. Until now, all the visualization-software companies were, in a sense, reporting tools that tell you what happened, not what could happen.” His model allows firms to target those midand lower-tier customers who have the potential to grow in the future. That’s not possible in the absence of the knowledge of customer attitudes. “What I can tell you is that using my methodology makes firms do better than they are doing right now. I can stand by that statement.” In fact, managers can actually increase revenue while contacting customers less because, as Venkatesan proved, too many sales calls or e-mails can backfire. “Each customer has his threshold.” The bottom line, according to Venkatesan, is to “pay attention to customer attitude as well as behavior.”

Raj Venkatesan, Bank of America Research Professor of Business Administration at Darden, co-wrote with Darden Professor Paul Farris the paper “Measuring and Managing Returns From Retailer-Customized Coupon Campaigns,” published in the Journal of Marketing (Volume 76, Issue 1, 2012). Venkatesan is also co-author with Darden Professors Paul Farris and Ron Wilcox of the forthcoming book CuttingEdge Marketing Analytics: Real-World Cases and Data Sets for Hands-On Learning (to be published in July 2014 by Pearson FT Press).

SPRING 2014

Darden Ideas to Action is published by the University of Virginia Darden School of Business Office of Communication & Marketing. P.O. Box 7225 Charlottesville, Virginia 22906-7225 USA communication@darden.virginia.edu Editor Juliet Daum Art Director Susan Wormington Graphic Design Convoy Photographer Stephanie Gross Writer Carlos Santos Copy Editor Catherine Burton

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