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Published: July 1, 2011

 
 

Lessons from Failure

Unsuccessful efforts to improve the status quo often have the richest silver linings.

Title: Reaching and Falling: Why Failure in Exploration Differs from Failure in Exploitation

Authors: J.P. Eggers (New York University) and Jung-Hyun Suh (New York University)

Publisher: NYU Working Paper Series

Date Published: January 2011

When failure strikes at a company, one of the most crucial questions is how to turn the negative outcome into a positive lesson. But not all failures are the same when it comes to teachable moments, this paper says, offering a reality check on what to expect when things go wrong.

The researchers focus on two broad types of corporate initiatives, using the mutual fund industry as a surrogate for companies in general. One type of initiative, which they call exploitation, involves the enhancement of the status quo through the refinement of existing routines and strategies or through increased investment in familiar markets. The second type, exploration, is the search for new areas of growth through experimentation, novel projects, or innovative technologies.

As one would expect, the researchers found that successful exploratory activities hold more worthwhile lessons for companies than failures do. In part, that’s because of the very nature of exploration: Cutting-edge mistakes are hard to process and, because they don’t involve the core of the business, easier to walk away from.

But when it comes to exploitation, firms sometimes have little to gain from massaging the status quo and much more to learn when they suffer setbacks. These mistakes do involve the core of the business and are taken seriously — and if studied well, they point to overlooked problem areas and untapped opportunities.

The researchers based their findings on an analysis of 40 years of data from the U.S. mutual fund industry. They used the University of Chicago’s Center for Research in Security Prices database, which covers the history of almost all open-end equity, bond, and money market funds between 1962 and 2002 (in all, 853 mutual fund providers are in the sample). The researchers also used publicly available data to document the history of each mutual fund company, including mergers and acquisitions.

To evaluate firm performance, the authors relied on one of the industry’s standard metrics: the net cash inflow into all new funds created by the mutual fund provider, a measure that is also closely correlated with firm profitability. The researchers deflated the cash flows to constant 1992 dollars. On average, the firms in the sample generated US$323 million of net new investment each year, had 17 years in the business, and managed $4.8 billion in assets.

All new funds created by a mutual fund company were classified by the researchers as either exploitative (meaning the fund was in a category in which the firm had prior experience) or exploratory (it was in a new investment category for the firm). Several mathematical models correlated the firms’ successes and failures with their subsequent decisions, showing whether they learned from experience.

To chart success against failure, the researchers compared the amount of cash flowing to each new fund during its first full calendar year with the amount generated by all other funds in its category. (The authors used the categorization developed by the research and consulting firm Strategic Insight, which assigns mutual funds to 83 groups, such as Municipal High-Yield Bonds, Global Total Return, and Tax-Free Money Market.)

Funds generating cash inflows that were greater than the median of all other funds in their category were considered initially successful; all others were failures. This approach is consistent with firm behavioral theory, the researchers note, and the premise that new funds generally outperform existing ones. (Accordingly, firms in the study had more experience with successful than unsuccessful funds.)

After crunching the numbers, the researchers found that organizations achieving success in exploitative activities, which merely reinforce the value of existing beliefs and processes, don’t learn much. Companies with above-average industry performance persisted with the same strategies, so that the routines that once afforded them success over their competitors constrained them in acquiring and developing new processes. Their performance faded over time.

The analysis also showed that firms learn valuable lessons from successful exploratory activities, because these ventures result in new knowledge that can be encoded and utilized by the firm.

But failures in exploratory activities are a costly waste when they don’t result in new information that can be distilled and used by the firm. Even relatively modest exploratory failures cost each firm about $192 million a year in expected cash inflows, the researchers calculated, an amount that declines over time. (Mutual funds base their varying fees in part on the size of the portfolios they manage, and the smaller inflows imply a loss of millions of dollars in potential revenue.) And because exploratory failures are “less core” to the business’s established identity, the authors argue, they can be more easily written off by managers, which limits the potential for drawing lessons.

But failure at exploitative activities can boost organizational learning and firm performance, the researchers also found, because the breakdown of established routines hits at the very heart of the business. Firms therefore react with more urgency to such problems and nip them in the bud. In the study, firms that failed at the familiar quickly turned things around: The authors write that each exploitation failure generated substantial new revenue for the firm going forward.

The findings apply less to extreme “disasters” than to more modest failures or near-misses, the researchers note. And there is a limit to what can be learned overall: Firms with the greatest diversity of experience — those that engaged in several different types of exploration and exploitation, to varying degrees of success and failure — actually performed much worse than others, the paper found. The researchers posit that too much tinkering in too many different areas can mean any knowledge gleaned is never fully incorporated and thus does not inform future projects. Instead, organizations need substantial experience in a given area to develop effective routines.

Bottom Line:
The effects of prior success and failure on future performance are linked to the nature of the experience — whether it involved breaking new ground or reinforcing the status quo. In exploring new territory, success is far more beneficial than whatever lessons can be learned from failure. But when it comes to established routines and processes, initiatives that end in failure can often provide more of a long-term boost to organizational learning and performance than those that are initially successful.

 
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