High-quality information and managers are essential to firms’ success, with the former allowing firms to accurately evaluate prospective investments and the latter helping to ensure those investments pay off. Yet the value of information and managers to a firm are usually assessed separately.
In a recent paper, we argue for a different approach, analyzing the value of a firm’s internal information jointly with the task of attracting the best managers and reach a surprising result: Rather than striving to make information as precise as possible, a firm may benefit from designing a noisy information system. More specifically, we find that, while firms can make investment decisions more efficiently by basing them on precise information, the precision of that information is inversely related to the ability of firms to attract high quality managers. Consequently, better internal information does not always lead to overall higher firm value.
We demonstrate this novel result using a theoretical model in which a firm considers a large number of candidates for the job of managing a risky investment. The firm does not know the true ability of any candidate, other than that some have better qualifications than others and seem more likely to succeed in handling the investment. The firm specifies the contract it is willing to offer, including an incentive award for success. Candidates willing to take the job on those terms form the pool from which one manager will be hired.
However, once the manager is selected but before the investment is made, the firm discovers additional evidence about the new manager’s likelihood of success with the investment. The evidence derives from the firm’s internal information system, perhaps from the board of directors or internal auditors. In practice, such information is often soft and subjective, reflecting how optimistic the directors or auditors feel about the prospect of the investment. The firm can decide whether to proceed with the investment before more costs are incurred. A successful investment produces positive payoffs to the firm and entitles the manager for the promised reward, while a failed investment imposes a cost on both parties.
The important question we examine is how the quality of the firm’s evidence about the likelihood of success for the investment affects the firm’s ability to attract the best managers and, ultimately, how that affects the investment’s value to thr firm? Intriguingly, while a more precise signal – one that is more indicative of eventual success or failure – allows the firm to make more efficient investment decisions, a noisier signal – one that is less correlated with the outcome of the investment – allows the firm to attract better managers.
The reason behind this seemingly counter-intuitive result can be illustrated with two extreme cases. First, suppose the signal from the firm’s evidence is perfectly informative: A positive signal implies definite success, and a negative signal implies definite failure. Then, all management candidates, regardless of their ability, will want to work for the firm because they understand that the investment will only be made once the firm receives a positive signal. In that case, even the worst candidates, the ones with the lowest likelihood of success, will find such a firm attractive, knowing that they will never bear the cost of a failed investment. The firm thus attracts the largest possible managerial pool and has a low probability of meeting a high-ability candidate from that pool.
In contrast, suppose the firm’s signal is completely uninformative: Whether the signal is positive or not has nothing to do with whether the investment will succeed. Then, because the managerial candidates also want to avoid the cost of a failed investment, only the best candidates – those endowed with the highest likelihood of success – will be willing to work for the firm. The candidate pool consists of only applicants most confident of their eventual success, and the firm has the highest probability of finding the best one.
Our analysis illustrates an important trade-off the firm should consider when designing its internal information system. Importantly, a marginal improvement of information quality does not always lead to an improvement of overall firm value. This resonates with some practitioners and researchers urging firms to use caution when obtaining information about investment activities of their managers, noting that too much information may have a negative impact that makes talented managers unwilling to work for firms.
Our study provides a related but different perspective. When considering management candidates of unknown abilities, the adverse effect of better information may exceed the positive effect of more efficient investment, resulting in a worse outcome for the firm, especially when managerial ability manifests in areas other than directing investments. This finding also provides a possible explanation for the variety of governance practices, such as the manner and intensity of firms’ internal monitoring or auditing or the degree of latitude managers have to make decisions. These diverse policies could be the result of firms’ balancing the direct effect of more informed decisions and the indirect effect of screening more capable managers. In particular, a lack of frequent monitoring and auditing or a large degree of discretion for the managers is not necessarily the result of failed internal governance.
The implications of our study also extend beyond corporate investment. For example, prestigious academic journals or grant committees often solicit registered reports or letters of intent from potential authors or applicants before passing a subset of those to formal review. Being subject to formal review but eventual rejection is usually costly to researchers in time and reputation. Consequently, our analyses suggest that journals or grant committees can benefit from a fuzzier screening process to improve the average quality of submissions. Likewise, high-ranking universities can adopt an early admission system that encourages exceptional students to apply before taking the standardized tests or before the test scores are released. In all these contexts, noisier information at the early stage may produce the positive effect of promoting self-selection, allowing a better match between the two sides in the later stage.
This post comes to us from Felix Feng at the University of Washington, Wenyu Wang at Indiana University, Yufeng Wu at Ohio State University, and Gaoqing Zhang at Carnegie Mellon University. It is based on their recent paper, “Ignorance Is Bliss: The Screening Effect of (Noisy) Information”, forthcoming in the Accounting Review and available here.