Practical analysis for investment professionals
30 December 2011

Leadership Lesson for the Eurozone: The Rule of Small Groups

Beginning with psychologist George A. Miller’s seminal 1956 paper, The Magic Number Seven, Plus or Minus Two: Some Limits on Our Capacity for Processing Information, scholars have consistently demonstrated that we human beings seem to have an upper limit to our ability to process information, especially within groups. For this reason, when it comes to group decision making, Miller argued, seven is the magic number. “There seems to be some limitation built into us either by learning or by the design of our nervous systems,” wrote Miller, “a limit that keeps our channel capacities in this general range.” Anthropologist Gregory A. Johnson, author of Organizational Structure and Scalar Stress, also reached essentially the same conclusion, although he caps the size of effective groups at a slightly smaller number, six.

Unfortunately, the spheres of investing and economic policy making do not account for this dynamic. Imagine the many groups that financial professionals encounter in their careers — boards of directors, investment committees, the G-20, and even the eurozone, to name just a few — and how important it is that these groups function and make decisions effectively. They often ignore the rule of small groups, however, causing the decision-making process to be cumbersome and often ineffectual.

So what is it about the number seven, plus or minus a person or two? Researchers across many disciplines have developed a working theory: the number of relationships through which information is exchanged grows exponentially with each additional group member, and the human brain is limited in its ability to function under such complex situations.

Studies nearer to finance have found an upper limit of seven as well. Consider, for example, Does Optimal Corporate Board Size Exist? An Empirical Analysis, by Yixi Ning, Wallace N. Davidson III, and Jifu Wang, in which they state, “We find a consistent and inverse firm performance board size association (t =-2.04, significant at 0.05 level). . . . We find consistent and inverse firm value board association across all three board size categories even when we control for board composition, CEO characteristics, inside ownership, firm size, firm performance, yearly effects, and industry effects.” In other words, the lower the number of board members the higher the value of the business, with the reverse also being true.


Correlation Between Board Size and Value of a Business

 

Board Size Coefficient t Significant at
<= 7 -1.441 -3.75 0.001
8-11 -0.734 -2.99 0.01
>= 12 -0.300 -1.69 0.10

 

Source: Does Optimal Corporate Board Size Exist? An Empirical Analysis.


Researchers have also found that investment committees typically deliver better results to shareholders when their size is seven, plus or minus two. According to Investment Committees: More than the Sum of the Parts, a compilation of research on the subject compiled by private wealth management firm Arnerich Massena, “Beyond a group size of four to seven members, larger groups become unwieldy and the disadvantages substantively outweigh any added value.”

Critically, studies find that groups can be effective when the size exceeds seven members, but only if a hierarchical structure exists. Johnson wrote, “The development of within-group leadership (hierarchical organization) appears to be most common in groups of six individuals.” Whereas, “horizontally organized (non-hierarchical) groups of greater than six members appear to be under some kind of stress as evidenced by decreasing consensus in decision making and decreasing member satisfaction with group performance.”

Johnson concludes, “There appear, then, to be rather severe limits on the maximum size of task-oriented groups that are organized (non-hierarchically), and these limits may be related to individual information-processing capacity. A wide variety of studies suggests than an effective limitation of group size is somewhere around six group members.”

Research into the functional limits of group size has important implications directly proportionate with the magnitude of importance of the group. For example, the decision to expand the G-8 to the G-20 may have been potentially disastrous. However, most reports have stated that the G-20 has adopted a more hierarchical structure in which several nations dominate the discussions. It’s likely that this helps to ensure greater efficacy in decision making.

Conversely, the eurozone’s 17 nations have adopted a consensus decision-making structure; something that studies have consistently demonstrated reduces the effectiveness of groups. Perhaps not surprisingly, the eurozone has had difficulties in crafting a policy and economic response to the greater European Union sovereign debt crisis.

In fact, many participants in the eurozone talks have complained about the ineffectiveness of the group apparatus. Even though internal decision making appears to be hierarchical, favoring Germany and France, externally, each member must agree upon a course of action.

Again, perhaps not surprisingly, one of the many areas for future discussion for the eurozone — if it survives its current crisis — is a decision-making structure that does not rely upon consensus. Researchers around the world, from anthropologists to business school professors, would no doubt recommend a group of eurozone decision makers made up of seven members, plus or minus two.

Of course, convincing eurozone politicians of the merits of this structure is a different story.

Jennifer Curry of CFA Institute substantially contributed to this piece.

 

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, is a content director at CFA Institute, where he tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor. Jason also ran a successful blog titled What My Intuition Tells Me Now. Previously, Voss was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund. He holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason.voss@cfainstitute.org

7 thoughts on “Leadership Lesson for the Eurozone: The Rule of Small Groups”

  1. pchepucavage says:

    This analysis confirms my experience with both corporate and non-profits completely and is an important lesson for the societies.The vertical horizontal paragraph is dead on.

  2. Thanks very much for your comment, I am glad that you liked the piece.

    With smiles,

    Jason A. Voss, CFA

  3. Gianmarco says:

    Hello!
    Interesting post…

    I have recently published an article also dealing with cognitive constrains to groups decision-making processes.
    May be it could prove interesting in the context of this blog page’s topic.
    The article is freely available from:
    http://www.plosone.org/article/info%3Adoi%2F10.1371%2Fjournal.pone.0091510

    Best
    Gianmarco Alberti

    1. Hello Gianmarco!

      Thank you for your praise, and also for including a link to your article, much appreciated. This error – too many people in decision making authority – is one I see repeated over and over and over and over and over and over [notice that I stopped at 6 ‘over’s].

      With smiles!

      Jason

  4. Update: you might also enjoy this piece from the Wall Street Journal published on 27 August 2014: http://online.wsj.com/articles/smaller-boards-get-bigger-returns-1409078628?mod=WSJ_hps_sections_business

    Spoiler alert: the research quoted also finds smaller boards perform better than larger ones.

  5. Victor Kamendrowsky says:

    Lenin seems to have known this a long time ago. The Central Committee of the Communist Party had six members.

    1. Hi Victor,

      Thank you for taking the time to comment on the post.

      Yours, in service,

      Jason

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