Harvard's Judgment Professor: The Curse of Optionality, and the One Habit That Builds Better Judgment

Speaker A: My biggest mistakes have been waiting too long to fire people. Like, no question. And it's not just what you think. It's not just that that person is underperforming and you can replace that person with a higher performer. There's something much more sinister when a founder or leader accepts underperformance, which is that it massively negatively impacts the entire cult.

Speaker B: That was Reza Sachu, Harvard Business School senior lecturer and six time founder on the hardest lesson of his career. I'm Motley fool analyst Rachel Boren. Last week in part one, Reza and I covered why judgment beats intellect in the age of AI, Whether judgment can be taught, and his billion dollar walkaway deal in student housing. This week in part two, we'll get into what it actually takes to raise capital without fooling yourself, why capital allocation is the sharpest test of a CEO's judgment, the curse of optionality, and the single habit that Reza wants every investor to build to train their own judgment muscle. We hope you enjoy.

Speaker C: You are both a, uh, serial entrepreneur as well as, you know, founder, investor. What are some of the hardest lessons you've learned? Um, as a founder?

Speaker A: So I will tell you, and this is, it's not even close and it's a harsh thing to say, but it's just my truth, um, which is my biggest mistakes have been waiting too long to fire people. No question. And it's not just what you think. It's not just that that person is underperforming and you could replace that person with a higher performer. There's something much more sinister when a founder or leader accepts underperformance, which is that it massively negatively impacts the entire culture. Okay. Which is suddenly people are like, well, he's not holding everyone to the same standard. Or well, you know, so, so, so I'd say to you that, but of course firing someone is a hard thing to do, right? Like you don't want to do it, right? Like, I mean, every time I fire someone, I, I, I remember the look in their eyes. I remember thinking about their family. I remember the part I would have played in it, that I misjudged the role or the hire or whatever it may be. So it's something that's very painful but is so necessary and the cost of not doing it and waiting is far greater than I think most people, uh, calculate it to be. So certainly if I think about my greatest mistakes, it's been waiting too long. Ah, waiting for perfect information to make an obvious decision when it comes to firing. Like not wanting to deal with the difficulty of firing someone. And as I said, it's not just the singular person's performance, it's the cultural impact of that. And so look, this obviously falls under a broader bucket, which is like human beings have an instinct to wait for too much information before they make a decision. But I think when it comes to firing, I'd say my personal, ah, view is I've waited too long on those and oftentimes I've waited too long to pull the trigger on people who on paper looked perfect. Right? Like, meaning they, they looked great on paper. And so you just were like, okay, they're going to figure this out. And um, you know, oftentimes like my world is founding businesses, but I've hired lots of people from larger organizations. Not always, but often they've had a very hard time working in a more resource constrained environment.

Speaker C: Interesting. You know, uh, going back to this idea of storytelling, it's obviously vital for raising capital, but it can be a bit dangerous in some cases if leaders or company leaders starts believing their own hype. So how do you assess whether a leader possesses, say, the intellectual honesty to separate their grand vision from a current operational reality? Whether that's the business, the industry, you know, both.

Speaker A: So let me take both sides of it. Let me sort of say, um, uh, what does it take to raise capital? Okay. Like what are the traits that it takes and how do you as an investor make sure that you're not being, um, hoodwinked by it? Okay, right. So, so let me, and I play both sides. I mean, I hope I haven't hoodwinked anyone, but I've seen both sides of it. Okay, so, so let's just say I, I have three words I use, and this is specifically for founders, but I think it can, you can extrapolate it for others as to when you're raising capital, what you need. So the first thing you need is authenticity. No one's going to give you their money if they don't trust you. Okay, Meaning you can't pretend to be someone else. You need to be pure, you need to be authentic. Okay. Two is you need to have momentum. There needs to be things that are happening fast and there's. People can see that there's action and you're getting customers or whatever it may be. The third one is perhaps the most important and the hardest, especially for a founder, is you need to convey a sense of inevitability. Okay, so authenticity, momentum and inevitability. So what does inevitability mean? Inevitability is not arrogance. What inevitability means is that you believe in your heart that this business is going to fly with or without whoever you are pitching. Okay? Meaning you have a mindset which is not that you are begging for money, but a mindset that you are the prize and that you're giving your investor an opportunity to make money. Okay. And that, that effectively, this is inevitable. Okay. Okay. But you can, uh, now to your question. You can imagine why that could lead to, you know, someone pitching something that, that framework can lead to nefarious behavior. Okay? So, so what I say, what I, what I'm always looking for. So I do think leaders should have those three traits. Meaning I do think if you're going to ask people for money, and you better believe that it's going to happen if you haven't convinced yourself, that's a problem. Okay? So what I'm looking for is a sense of humility within that inevitability framework. And also what I, what I love, what I love seeing is founders, leaders, addressing the inevitable negatives in their business, like the inevitable risks. And starting with that, like, I love it when a founder or leaders. And you don't lose any inevitability when you do that, frankly, because every business has risks associated with it. And what you get as a founder is you get to actually articulate the narrative around that risk. So from my perspective, I am always looking for someone because when I get pitched and it's all sunshine and roses, I'm just like, this is ridiculous. But if I'm getting pitched by someone who, yes, believes it's inevitable, but is also talking about all the competitive threats and the technological issues and how they're going to deal with it and what their plan is, knowing that it might change, that to me is a much more authentic, uh, proposition and for me feels, um, much more believable because they know what the issues are. So just tell me what the issues are and let's figure out how you're going to solve them. Because there's no business without issues. So I think I don't want to make it as trite as lead with the bad news. I would just say that I do respect leaders who articulate in a very clear manner the inevitable risks that they're facing and take the opportunity to address them and have a real conversation about it.

Speaker C: I think it was Warren Buffett who once said that capital allocation as a CEO's most important job. When you look at a leadership team's or a leader's capital allocation history, uh, what is a pattern that maybe tells you they're playing a long term game rather than just managing short term expectations.

Speaker A: Yeah. So look, I think it's funny, right, because capital allocation at the core is the sharp edge of judgment, meaning that is where judgment is most shown by a CEO. Right. So meaning when we talk about how you evaluate it, what you've just identified is how is it demonstrated from a CEO's perspective? There's no better way for you to evaluate a CEO's judgment than to see the capital allocation decisions they've made. Okay, So I think you've hit on exactly the point as to how we evaluate, like what is the metric we should look at? Um, if we wanted to sort of evaluate judgment for a CEO, it's really these decisions around capital allocation. It's probably the most important decision. And so, so I think, I think your point is exactly the right one, which is there has to be a timeframe, um, that is not about keeping my job for the next quarter or hitting short term results, but much more about how to actually build a business that long term is going to be a great compounder of capital, uh, for myself, for the CEO, and for his or her investors. And so I think the way to, to look at it is, I mean, there's no better way to evaluate judgment than to look at previous judgments that they've made. So I think, I think the way to look at it, Rachel, is to say, okay, I would ask the question, tell me what the three most consequential capital allocation decisions that you made that worked and the three that didn't work. And um, you know, I think through that lens you would quickly understand, are they thinking about capital allocation from a short term perspective or long term perspective? Right. Because if they're suddenly you're talking about a capital allocation decision that, you know, was measured in months rather than years, that tells you something. But I also think that the learnings that they can convey from the ones that didn't work out are also critically important. And so, uh, and I think the thing that you're hitting on, which I think is very important, is what let them answer it in a way where they're evaluating the time horizon. And so, you know what I'd be looking for is what time horizon are they looking for to measure these decisions.

Speaker C: Yeah. In your own ventures, how have you balanced the tension between conserving cash and aggressively deploying capital into growth?

Speaker A: Yeah, I mean, look, it's such a tension point. And, um, I'll give you an example of a business where, um, okay, so we talked about the student housing business. So the student housing business was one where, where when we had that offer for a billion one and we sold it for a billion seven, we actually made about $300 million of acquisitions in that year. Okay. Which ultimately was well worth it because we generated an additional $400 million of equity value as a whole. Okay. But we needed to deploy capital quickly in that year to get to that valuation. So that's an example of where we, we made the right call and we decided to do it. And there was a number of, you know, there were international students that were coming in. There was still a spread between student housing cap rates and multifamily that we thought was going to compress. There was a massive institutionalization of the student housing market with lots of pension funds, Brookfield, cpp, Temasec coming in. So there were, there were lots of tailwinds that we thought were going to be helpful to us over the next year or so. Okay, let's take another story. So a business that I had founded beforehand, uh, with my brother actually was a storage business, actually. And Kevin o'. Leary, the three of us founded it, um, a storage business. And, um, there, look, we did very well. I mean, we, we sold the business for $110 million in 2007. We started in 2003. But I would tell you we made a massive mistake. Okay. We should have kept deploying capital. Like, we had a brilliant idea. We.

Speaker D: Right.

Speaker A: We were the first people to do sort of multi story, um, uh, urban, high household income focused storage in can. This was in Canada. No one was doing it. Everyone was doing sort of single story in the middle of nowhere. And we had this idea and we should have tripled down like we should. This should have been a billion dollar business. But we made, uh, an inaccurate decision, which was we thought that we should have taken the money off the table as opposed to deploying more capital. So I think what I'd say, Rachel, when I got to student housing, I was like, I am not going to make that mistake again. Like, I'm going to learn from that mistake and really think hard about this. But I think this is where there's no science. It's really a judgment call around all the various issues. So storage is an example of one where we made a judgment that I would say is flawed. Um, I mean, we did fine. I think we made four or five times our money, but we could have made 20 or 30 times our money in that business. That should have been a billion dollar business. But we learned and in student housing, I think we, we calibrated the risk appropriately. Now, like in anything in life, it could have gone the other way, but it was the right decision. Based on the factors of time.

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Speaker C: You know there was, uh, an HBS case, uh, study session you did with Tim Ferriss where he focused on the curse of optionality and I wanted to ask you a bit about that. This idea that having too many path analysis paralysis.

Speaker A: Talk to me about that. So Rachel. So I. Look, I talk a lot about this in my podcast, the Founder Mindset, where. Where, you know, you invariably see the folks on my podcast, whether it's everyone from, you know, Reese Witherspoon to Mark Cuban to Michelle Zatlin. What you see is ultimately the impact that they've been able to have. The impact that, you know, every human being wants to have has come about because they have committed to a certain path, okay? And they've shut off a bunch of options. So I started thinking a lot about the curse of optionality, because here at Harvard, you have these students who collect gold stars for a living. Like, literally, you know, they've gone to, you know, Stanford undergrad, they worked at Goldman Sachs. They then go to kkr, then they come to hbs. Like, literally every box is checked, okay? And many of them, you meet them and you're like, wow, I can't believe you were born to this single mother in Birmingham, Alabama, or you were born in this family in India, wherever it is, and you managed to get to Harvard Business School. The trajectory was so steep. It was so improbable. And then you come to a school like this and you do entirely probable things. You go take a job at McKinsey or you go take a job at Goldman. Like, you take these jobs that are entirely available to our students. And of course, the reason that's happening is because they're just preserving options, okay? They're preserving options. And so because they're like, well, we'll commit to something in the future. And this just allows me to learn more, see different things, and at some point in my life, I will commit to the thing that I really want to do. Um, I mean, it actually raises a much broader societal point, Rachel. And I'm actually writing a book about this, which is, um, I think society there is a massive existential risk to our society, which is that people view commitment as a sacrifice and not as a superpower. Okay? So what you're seeing is that forms of commitment are declining dramatically across. All. Across all of our lives, right? So there's a decline in marriage, there's a decline in people having kids. There's a decline in home ownership, there's decline in people going to church, whatever. The thing is that people used to commit to is declining, and it's been replaced by options, okay? Most acutely, you swipe left, you swipe right. You know, there's lots of options at all times, right? And my argument to you is that at the end of your life, and there have been lots of studies. In fact, Harvard did a study, unfortunately, it's just of men, but they had 800 men. It's the longest longitudinal study of happiness over the past 60 years. They, they tracked 400 men who graduated from Harvard in the 19, uh, 30s, 40s, 60 years ago. Uh, no, I guess the 60s. And 400 men who were in the inner city, okay, they're now 550 of them are still alive in their 80s. And they said, to what do you attribute your contentment? And by a long shot, the thing that, uh, came up was, did I have long term enduring relationships? Now the thing about long term enduring relationships is they all go through crises, okay? And it takes commitment. And so commitment is sort of this superpower, I believe. And it's the same thing with this curse of optionality, which is around, you know, founding, which is, I think everyone should be a founder. Like, everyone should have a founder mindset in the age of AI.

Speaker B: Ah.

Speaker A: Like, I really believe that. Like, I think of everyone should because. Because it's judgment that we're trying to build. And where judgment matters most is when you're actually stepping into the arena, commit, cutting off other options and seeing what you're truly capable of when you commit. And so I think optionality, look, every option has value. But what's being massively underpriced in this world is what commitment does, which is, you know, and what I say about commitment, Rachel, is it's not just the obvious thing, which is you learn what you're capable of when you truly commit to something, to a path. There's a second order thing that happens, and I call it magic. Okay? And the magic happens when people commit to you precisely because you've committed. So I can't tell you how many times I've experienced this, where the first investor shows up, the first customer shows up, my first employee shows up, precisely because they see the commitment from you. And so it's a magical thing, right? And so, uh, uh, what I try to teach at the core is how do you commit to, uh, a thing in the face of massive options? Because I think it's through that commitment that you will have the impact that you most want to have.

Speaker C: Something that I've seen you do on your podcast, the founder mindset is.

Speaker A: Thank you for watching it.

Speaker C: Asking company founders and leaders to revisit the moments of doubt that terrified them. Um, so I've got to turn that around and ask you, you know, in your, in your journey, building, you know, six, what is the most terrifying decision that you had to execute before you knew it would work.

Speaker A: Yeah. Okay, so. So my wife has a joke where she says, raise it. If things are too calm, you blow things up. Like, I actually. Like, it's. I think it's. I'm. Like, it's a pathology or something. But I will say to you that I actually want a really uncomfortable, uncertain life. Like. Like, I actually crave uncertainty and risk. Okay? Not because I want to jump off a cliff, but because I'm not arrogant enough to believe that I can have the impact I want to have without taking risk. Right? Like, the equivalent of having real impact and not taking risk is investing in a bunch of T bills and getting S&P 500 returns. It doesn't happen. Okay? So I want to just start with the proposition that I think a life of certainty and a, uh, life without risk is in many ways quite inconsequential. Okay? Meaning I think we need to reframe how we think about risk and uncertainty and adversity. It is a good thing, not a bad thing. Okay? It is where learning really lies, because that's where judgment is built. Okay? So I just want to start with that just framework, which is. I don't view the crises or the adversity as. I mean, in the moment, maybe they feel bad, but I know they're part of the learning and the journey to be able to generate the resources that I want, to have the confidence, the credibility, et cetera, to have the impact that I want. Okay? So I start with a mindset which is, this is going to happen. Okay? It's good. Like, there will be adversity, there will be crisis. And the question is, can I stay committed? Uh, you know, how can I respond in these moments? Okay, But. But look, there's no question there are moments where there is complete terror. Okay? And so, um. And I don't know if terror is the right word, but what I'd say is, like, I. As a founder, this idea that you're ever certain about anything is just not true. Okay? Like, meaning these decisions are like, 51, 49, 60, 40. They're not 99 1. Okay? And so. But what you realize is you have a right to recover. And even in sort of failure, there's real. But. Okay. You know, the hardest decision I made was a business that I started that ultimately failed. And, um, you know, I had been investing personally in a bunch of hedge funds. So, you know, I was an investor in Pershing Square, Lone Pine, some very fancy hedge funds. And I met a fellow, um, who was an academic who Basically was talking about how the best way to evaluate hedge funds. And it sort of married up with my own instincts. So we created a company called Stellation. We very quickly raised a few hundred million dollars to invest in the world's best hedge fund managers. Okay. And I made a very difficult decision, um, during the crisis to give back the capital to my investors before we had any meaningful redemptions. And I did that because I was very concerned about the stability of our partnership. Right. And I was worried about our scale, whether we could get. Now, it turned out to be the right decision. Okay? And I think my investors appreciated it. But you can imagine, from my perspective, it was an incredibly difficult decision because it was a public failure. Okay? Now, what I'll tell you about failure is it turns out. Look, I'll tell you one last thing on failure, which. Which, not only do I think we, as a human being, sort of overestimate how bad failure is, but I'd also say the market values people who actually exercise judgment and fail so quickly. One of my colleagues here at Harvard did a study where they looked at 5 million data points, and they only looked at two types of people. People who went and did traditional paths and people who founded and failed. Okay? So people who went to McKinsey, Goldman, Google, Amazon, whatever, others who founded and failed, forget about founded and succeeded. And then they grouped them, um, in terms of, uh, similar prior historical, educational, and professional experience. And what they found was the failed founders reentered the workforce with two and a half years of seniority above the traditional folks.

Speaker C: Wow.

Speaker A: So think what that tells you. What that tells you is the market values their judgment even though it was flawed. They valued the fact that they were in the arena, making decisions, feeling the consequences of it, calibrating risk, however flawed, such that they came back into the traditional world with two and a half years of seniority. And it makes sense to me because even if you're getting it wrong, you're building judgment. You're seeing what it's wrong. So I think, you know, these are, um, important sort of, um, moments and certainly important educational objectives.

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Speaker C: You know, something that you've written and talked about is that what looks inevitable in hindsight usually look completely irrational in real time because maybe the market signal hadn't formed. So I wonder how can one tell the difference between, say, a management team making a brilliant, irrational, but correct bet versus one that might be drifting off course?

Speaker A: So it's interesting because of course, I see it, um, from the framework of a founder, right? Like I almost inevitably, when you think about a founder, right, effectively what a founder is doing is imagining a world that doesn't exist today and they're trying to convince you of that world. And almost everyone can't see it. And it's logical that they can't see it because at least if everyone could see it, the opportunity wouldn't be there, right? So the fact that they can't see it is why the opportunity is so large. But it often takes one person, first investor, first customer, first, um, employee to, I say, behave almost irrationally, right, like to actually be the first person to come and join. And so the question is, why do they do that? Why does someone, how do you differentiate between a founder or CEO who's, you know, sort of a snake, oils person, salesperson, versus someone who actually can see something that you can't see? And I think, again, it just goes to this. You know, what I look for is sort of integrity, humility, and then also what I Call sort of this X factor, which is you could imagine this person, if they're right, being really right. Like, being really right. Like they have something about them where if they are either some combination of lucky and. Or good, this could have a hundred X outcome. Right? And it's worth taking a shot. And so I think. I think in the public context, it's so interesting because in some senses, you know, you'd say, look at their previous judgments to see how they turned out. But we also know that we're living in such a different world now where things are changing so quickly that people have to come up with new frameworks immediately. And so, again, I go back to, yes, I want you to paint me a vision, and I want to be excited about the vision. But what I really want to do is make sure you tell me what all the risks are and that you articulate them and tell me how you're going to defend against them in a way that makes real sense to me.

Speaker C: As a founder, do you think you have learned more from your successes or from failures?

Speaker A: Well, it's a great question. You know, it's funny. Um, I think, um, as a founder, you almost invariably have to be an optimist, okay. Because you have to believe in things that others don't believe in. So I focus much more on how things can go right than how things can go wrong. Okay. Because if you focus on how things can go wrong, you will never build anything, because almost invariably, as a founder, you are always competing with people that have more resources than you do, more information, more expertise. Uh, one of my professors defines, and I think it's a great way to define entrepreneurship. Entrepreneurship is the relentless pursuit of opportunity without regard to resources currently controlled. That second half is the critical part. Rachel, everyone knows you got to be relentless, but the hardest part about being a founder is you got to do it without regard to resources currently controlled. Okay, so what that means is you are not resource constrained. You're purely opportunity driven. Okay? So. So what I'd say to you is, to answer your question, I think I remember my failures. I think a lot about them. I hope I've learned from them, but I'm in this game to celebrate my successes, like meaning or my team successes, you know, and so. So here's what I'd say. I think I've learned a lot from my failures, but I remember my successes much more. Yeah.

Speaker C: Uh, one final question for you as we draw to the end of our time together. If our listeners, investors wanted to leave this episode with just a daily Habit, a mental exercise, an actionable question that we can ask ourselves to train that human judgment muscle. What would it be?

Speaker A: Okay, I'll tell you. Rachel and I hope, and we talk a lot about this in my podcast, but I really hope, um, this resonates with your listeners. Um, every one of your listeners can go through life and will see ideas of things that can be better, okay? Products, services, health care, whatever it may be. And they'll look at it and they'll say, wow, this is a problem for me. I'm sure it's a problem for others. I can do something here. And invariably what will happen is they will dismiss the idea. And they will dismiss it because they will think there is surely someone else who has more resources that has thought about, uh, this. And I'm not going to spend any time, okay, What I desperately want your listeners to do, I don't want them jumping off a cliff into shark infested waters into this idea. But what I want them to do is what I call do small C commitments, okay? What I want them to do is the next time they get that idea is take a small step, okay? Not an inconsequential one. One where you're like late for dinner and you stop in to actually talk to the customer, or one where you like, miss your flight in order to explore the actual idea. Okay? My point is just start trusting your judgment on these small things, okay? The way you ultimately can actually enter into the founder arena and actually m jump in is by testing yourself repeatedly and what you might find and what I suspect you'll find, and certainly what I found. Every business that I've built, which have been in completely different industries, have not been born because I have an, uh, sort of experience advantage or capital advantage. It was because I trusted my judgment to sort of do the small things, to suspend disbelief that other large competitors missed it. But only because I stopped the car, knocked on the door, whatever, it picked up the phone, um, to do the small things. And so the actionable step is the next time you have an idea, do something small to explore it. And guess what? Nine times out of 10, it'll be a waste of time. But there'll be one time out of 10 where you'll be like, wow, this is interesting. Maybe I should take a little more time here.

Speaker C: Um, well, I love that. And, uh, thank you so much for joining me today, Rez.

Speaker A: I appreciate it, Rachel, thank you. Nice to meet you.

Speaker B: As always. People on the program may have interests in the stocks they talk about and the motley fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. For the Motley Fool Conversations team, I'm Rachel Warren. Thanks for listening, and we'll see you next time.