It’s a wet Sunday afternoon and I am sat in a coffee shop writing this article. My youngest son is at a birthday party and my eldest son is sat opposite me doing his school homework (admittedly, he is doing it after being bribed by millionaire’s shortbread, but he is doing it).
I am re-reading “Thinking, Fast and Slow” by Daniel Kahneman1 and am at the part describing his famous Prospect Theory2 (about making decisions under risk), and how it differs from classic Utility Theory3. I also remember reading how Daniel Kahneman and Amos Tversky (his friend and long-term collaborator) used to spend many an hour discussing their ideas and research in restaurants.
Now, whilst I am not (yet!) discussing Prospect Theory and Utility Theory with my eldest son, and I am definitely not putting myself in the same scholarly category as Messrs Kahneman and Tversky, I do feel some affinity with them based on the environment I am in now.
I’m going to (attempt to) explain Prospect Theory and Utility Theory, and then discuss the application of these to projects. You may want to first grab a brew and a chocolate hob-nob, and settle in for the ride!
The Theories
Before getting to the subject of this article, an explanation of Prospect Theory and Utility Theory (as I understand it) is required. In particular, I am looking specifically at three principles:
and my explanation and examples are taken from the book. I also take this opportunity to state that any errors, misunderstandings, omissions, incorrect interpretations etc. in my explanation are entirely my own.
Utility
Utility is defined as the ‘relationship between the psychological value or desirability of money and the actual amount of money’. Professor Kahneman goes on to say that in utility theory, the utility (i.e. psychological value or desirability of money) of a gain is assessed by comparing the utilities of two states of wealth.
Using the example cited, the utility of gaining $500 on your wealth of $1m is the difference between the utility of $1,000,500 and the utility of $1m (the two states of wealth being $1m and $1,000,500).
Likewise, if you own the larger amount, the ‘disutility’ of losing $500 is the difference between the utilities of £1m and $999,500 (the two states of wealth being £1m and $999,500).
Professor Kahneman goes on to discuss that in utility theory there is no way to represent the fact that the ‘disutility’ of a loss could be greater than the ‘utility’ of winning the same amount. The psychological value (or desirability of money – i.e. utility) is different if you have $1,000,500 (a gain) or $999,500 (a loss).
Professor Kahneman explains that you need to know only the state of wealth (as discussed above) to determine its utility, yet this is too simple and lacks a ‘moving part’: the reference point – the ‘earlier state relative to which gains and losses are evaluated’.
Outcomes that are better than the reference point are gains, and below the reference point they are losses. This is one of the fundamental principles of Prospect Theory: you need to know the reference point.
Diminishing sensitivity
Another principle of Prospect Theory is diminishing sensitivity when it comes to the evaluation of changes of wealth. The example cited is that the subjective difference between $900 and $1000 is much smaller than between $100 and $200.
Professor Kahneman explains this (rather eloquently) as turning on a weak light has a large effect in a dimly lit room, yet the same increment in light may be undetectable in a brightly lit room.
Loss Aversion
The final principle of Prospect Theory is our psychological response to losses is stronger that our (psychological) response to corresponding gains – this is famously known as Loss Aversion. Imagine a toss of a coin.
If it lands on heads you win $150 and if it lands tails you lose $100. Would you accept a gamble based on these terms of the toss of a coin? For most people, the fear of losing $100 is more intense than the hope of winning $150: losses loom larger than gains.
The Application
It is these principles of Prospect Theory that got me thinking about how they may apply to projects. Prospect Theory is described in terms of ‘Dollar Amount’ and ‘Psychological Value’, and I am going to use ‘Dollar Amount’ in the next part of my discussion in the terms of financial return on investment (or benefits), yet acknowledging that project benefits are not always expressed in financial terms.
The fundamental ideas of Prospect Theory are that reference points exist and that losses loom larger than corresponding gains, and I use these to think about how these contribute to the success (or, indeed, failure) of projects.
Loss aversion refers to the strength of two motives: we are driven more strongly to avoid losses than to achieve gains. A reference point is sometimes the ‘status quo’ but it can also be a goal in the future: not achieving the goal is a loss, exceeding the goal is a gain.
As a vehicle for implementing change, a project can be defined as a temporary endeavour undertaken to deliver outputs that will (hopefully!) manifest in the delivery of benefits to an organisation. Change, by definition, invokes different feelings amongst the organisations’ staff, including that of resistance.
Consider now if, on a project, the reference point is the organisational ‘status quo’ – i.e. the existing organisation capability/state – then a project (introducing change) represents a departure from this status quo, with the intention to achieve a gain.
Or to think of it another way, the intention of a project is to move the status quo to a better/superior reference point, which then becomes the new status quo. This is often a question I ask people: “does a project always result in a better/superior future state”?
At the macro (organisational) level, the answer must be ‘yes’, but at the micro (individual) level the answer may be, and often is in my experience, ‘no’. Would you ever be able to justify an answer of ‘no’ at the macro level?
Will all stakeholders view the project as better/superior (i.e. a ‘gain’)? Will everyone consider that the outcome achieved (the new better/superior reference point – the ‘gain’) is better than the original reference point?
I am deliberately stating this in the past tense – in that the project has finished and the outcomes have been achieved. Yet on a project it is also about perception – will the intended outcome be perceived as a ‘gain’/’loss’ to stakeholders?
Prospect Theory says that losses loom larger than gains, and that we are driven more strongly to avoid losses than to achieve gains. What could this mean for those stakeholders on a project that perceive the intended new organisational capability/state as worse/inferior to what exists now? Well, they will perceive the new status quo as a ‘loss’.
Does this mean for these stakeholders that this perception arises because their preference is to maintain the ‘status quo’ (i.e. avoid their perceived ‘loss’) as they perceive that the project has no benefit?
If we start talking in terms of ‘Dollar amount’ this could manifest in the perception of wasted money, or maybe even the opportunity cost of the project (i.e. what this projects’ budget could have been spent on instead, or what ‘gain’ the alternative spend of the budget could have achieved) – another form of ‘loss’, in essence.
We start to get into ‘diminishing sensitivity’ the more the project goes on and the more money is ‘thrown at it. ‘Throwing’ another $10,000 at a project to keep it going on an original budget of $1,000,000 would have a subjective difference compared to ‘throwing’ another $10,000 on an original budget of $20,000.
It is likely that we are guilty of what Professor Kahneman calls the ‘sunk cost fallacy’ – the decision to invest additional resources in a losing account (i.e. the project) when better investments are available.
So, what can be done to counter these effects on a project? There is never going to be a ‘perfect’ solution that results in every stakeholder perceiving the project as a ‘gain’, and it would be unrealistic or, dare I say, naïve to have this expectation.
We could also utilise the fact that some stakeholders may perceive the project as a ‘loss’ by having them undertake the role of ‘critical friend’ and ask the probing ‘why’ questions – especially around business justification.
My article Affecting Business Cases looks at some psychological effects that may come into play when creating business cases, and the potential use that a ‘critical friend’-style role may have.
Unquestionably, Leadership and Vision have to play a key role. If people are perceiving the new organisational status quo as a ‘loss’, then the organisation needs to be ‘engaging the heart as well as the head’ from the outset.
Whilst focusing on Project Plans, and Business Cases, and Risk Registers (engaging the ‘head’ in this context) are all essential parts of successful projects, are they really going to ‘engage the heart’ of those stakeholders who are resistant to the change?
Coupled with diminishing sensitivity and sunk cost fallacy, this would only compound any sense of ‘loss’ for these stakeholders (“I knew it wouldn’t work and now they are throwing good money after bad”).
Clearly there is a need to ensure the project is viable and achievable in the first place, yet once it has been deemed so it is then into the realm of Leadership and Vision to ensure it is (and continues) to be perceived as a ‘gain’.
References
1Kahneman, D (2011). “Thinking, Fast and Slow”, Penguin Group. ISBN: 978-0-141-03357-0
2Kahneman, D and Tversky A (1979). “Prospect Theory: An Analysis of Decision under Risk”. Econometrica, 47(2), pp. 263-291.
3Bernoulli, D (Jan. 1954). “Exposition of a New Theory on the Measurement of Risk”. Econometrica, Vol. 22, No. 1, pp. 22-36
