Gains and losses: What are your prospects for a successful project?

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, after being bribed by millionaire’s shortbread, but he is doing it).

I am re-reading Thinking, Fast and Slow by Daniel Kahneman [1] and am at the part describing his famous Prospect Theory [2] (about making decisions under risk), and how it differs from classic Utility Theory [3]. 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, while 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 explain Prospect Theory and Utility Theory, and then discuss the application of these principles to project management. 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 at three principles:

1. Utility

2. Diminishing sensitivity

3. Loss aversion

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.

1. Utility

Utility is defined as the “relationship between the psychological value or desirability of money and the actual amount of money”. Professor Kahneman says that in Utility Theory, the utility (the psychological value or desirability of money) of a gain is assessed by comparing the utilities of two states of wealth.

Using his example, 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 utility – the desirability of money) is different if you have $1,000,500 (a gain) or $999,500 (a loss).

He 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 those below the reference point are losses. This is one of the fundamental principles of Prospect Theory: you need to know the reference point.

2. Diminishing sensitivity

Another principle of Prospect Theory is diminishing sensitivity when it comes to the evaluation of changes of wealth. The example he cites 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 which has a large effect in a dimly lit room, yet the same increment in light may be undetectable in a brightly lit room.

3. Loss aversion

The final principle of Prospect Theory is that our psychological response to losses is stronger than 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 on tails you lose $100. Would you accept a gamble based on these terms? For most people, the fear of losing $100 is more intense than the hope of winning $150: losses loom larger than gains.

Let’s apply Prospect Theory to project management

These principles of Prospect Theory got me thinking about how they may apply to projects. Prospect Theory is generally described in terms of “dollar amount” and “psychological value”, and I am going to use dollar amount where I discuss financial return on investment (or benefits), but I acknowledge that project benefits are not always expressed in financial terms.

I’ll apply the fundamental ideas of Prospect Theory – reference points and loss aversion – to consider how these contribute to the success (or indeed failure) of projects. Loss aversion in the project context refers to the strength of two motives: we are driven more strongly to avoid losses than to achieve gains. A reference point would sometimes be 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 among the organisation’s staff – including that of resistance. Consider now if, on a project, the reference point is the organisational status quo – the existing capability or 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 or 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 or superior future state?” At the macro (organisational) level, the answer must be “yes”. Would you ever be able to justify an answer of “no” at the macro level? But at the micro (individual) level the answer may be, and often in my experience is, “no”.

Will all stakeholders view the project as better or superior (a gain)? Will everyone consider that the outcome achieved (the new better reference point) 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 or loss to stakeholders?

What could Prospect Theory’s principle of loss aversion mean for those stakeholders on a project that perceive the intended new organisational capability or state as worse or inferior to what exists now? If losses loom larger than gains, and we are driven more strongly to avoid losses than to achieve gains, well, then they will perceive the new status quo as a loss.

Does this perception arise because the stakeholders’ preference is to maintain the status quo (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 – that is, what this project’s 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 (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 where every stakeholder perceives the project as a gain, and it would be unrealistic or, dare I say, naive to expect this. 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.

While focusing on project plans, business cases and risk registers (the head) are all essential parts of successful projects, are these really going to engage the heart of those stakeholders who are resistant to the change? Coupled with diminishing sensitivity and sunk cost fallacy, only engaging the head would 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 up to leadership and vision to ensure it is (and continues) to be perceived as a gain – by everyone.

References:

[1] Kahneman, D (2011). “Thinking, Fast and Slow”, Penguin Group. ISBN: 978-0-141-03357-0

[2] Kahneman, D and Tversky A (1979). “Prospect Theory: An Analysis of Decision under Risk”. Econometrica, 47(2), pp. 263-291.

[3] Bernoulli, D (Jan. 1954). “Exposition of a New Theory on the Measurement of Risk”. Econometrica, Vol. 22, No. 1, pp. 22-36