The causes of risk taking by project managers

This paper addresses the cognitive psychological reasons for risk propensity among project managers. It explores the effects of various organizational structures on the willingness of project managers to assume varying degrees of risk within the project and relative to the strategic initives of the organization. Willingness to take risks is often a differentiator between the successful project manager and the “average” or unsuccessful project manager (MacCrimmon & Wehrung 1989).

Project managers are responsible for making many decisions. Often, after sufficient information is gathered for an educated decision to be made, the decision-maker fails to make the correct decision or fails to make any decision. Uncertainty induces inaction. The project manager needs to seek sufficient information to resolve residual uncertainty in others to cause them to respond. When people are uncertain they tend to look to other people who they view as similar to themselves for acceptable solutions (Cialdini 1993).

Too much information gets in the way. When additional information is added people tend to do nothing or refer the decision to others. New information tends to receive more weight in a decision versus old information, regardless of validity of the information (Bernstein 1998). The project manager must learn to balance information within the scope of the project.

Existing validated information is frequently ignored in favor of information that supports an underlying belief system that is held by the decision-maker. Psychologists Amos Tversky, Daniel Kahneman, and others have demonstrated that such irrational decisions are predictable. Studies have peen performed by prominent economists and social psychologists to support this contention.

This paper explores risks to successful completion of projects due to the propensity of project managers to ignore good information. The cognitive biases often lead to a misunderstanding of both the probability of the occurrence and potential impact of a possible risk event. This paper explores the reasons for misunderstanding and misinterpretation of information. It suggests methods that can be used to recognize when such biases are imposed on the decision process so that the impact of cognitive bias can be reduced.

People tend to accept risks when faced with the high probability of a sure loss. Actuarially acceptable risks are refused when likely gains are offered. Project managers accept the risk of a failed project when faced with the sure loss of already sunk costs. They either fail to recognize or accept that sunk costs are already lost. The personal perceived loss of having made a poor decision or that the project was poorly managed outweighs the knowledge that the purpose of the project may no longer be valid. This paper explores factors that motivate project managers to accept risks that are unreasonably high while they refuse risks that are almost certain gains. Research is presented showing that people respond with more sensitivity to negative stimuli than to positive stimuli. The result is that project managers frequently implement reactive responses to risk events rather than use proactive risk management.

The cognitive psychological theory known as failure of in-variance holds that the framing of a problem will determine the choice that is made to approach a solution to the problem. When a problem is framed in a manner that appears to be logically sound, the problem solver will accept the framing and attempt to solve the problem in conjunction with way the problem is framed. Project managers are at risk of making incorrect choices if a client or other stakeholder states the problem is incorrectly, yet logically. Several research studies are cited that demonstrate this behavior among subjects.

Failure of invariance demonstrates that a loss that is taken is often perceived as an acknowledgement of error on the part of the decision-maker. The result is that a perception is made that the project manager has made a poor decision rather than examination of the underlying information that was available at the time the decision was made. Subjective probability judgments are then made based upon the description of the events that surround the information. The decision-maker may judge the probability of an event based upon the explicitness of the description of the event rather than strictly upon the actuarial or objective information that has been obtained.

Another important aspect of cognitive psychology that influences the propensity of a project manager to assume risks in the project environment is known as “mental accounting.” This is the tendency to separate the whole into components. The result is often the failure to recognize the impact of a decision on one area of the project on other areas that have no direct interrelationship. The same decision-maker may obtain conflicting solutions to related questions.

Risk Propensity

A person is generally considered to be risk averse, risk neutral, or a risk taker. The same person may assume any one of these propensities in different situations. The risk averse person tends to perceive the problem in terms of potential gains. This person requires a large potential gain relative to a sure gain before the risk will be taken. A person who is risk neutral is indifferent between a sure gain or a gamble that will likely return the same gain. The risk taker tends to view the options in terms of a sure loss versus a potential loss. The risk taker will prefer the risk to acceptance of a sure loss. Research during the past twenty years has continued to corroborate these postulates (Tversky & Kahneman 1979; MacCrimmon & Wehrung 1989).

When given a choice between the following two projects

1. Project A will generate a sure $100,000 profit.

2. Project B has a 50%/50% chance of success. If it succeeds, it will generate $200,000 profit.

A risk averse project manager will accept the sure thing even though they are actuarially the same. This person may accept the gamble if the expected profit from Project 2 was $500,000.

A risk neutral person will be indifferent to the two choices.

When given a choice between the following two projects

3. Project A will generate a sure $100,000 loss

4. Project B has a 60% chance of failing and a 40% chance of success. If it succeeds, it will generate break even and if it succeeds it will break even.

A risk taking project manager will accept the gamble even though it is actuarially the worse choice.

MacCrimmon and Wehrung have shown in their extensive study of more than four hundred managers and executives across North America that although both are generally risk averse, a differentiator for executives is that they are willing to take calculated risks. They state that, “Chief executive officers and chief operating officers took more risks than did lower level managers.” They hold that, “top executives are at the top because they have taken calculated risks that have paid off.”

Project managers tend to view their project as the universe in which risks will be assumed. They tend to ignore the impact of a trial project relative to the asset base of the corporation as a whole (MacCrimmon & Wehrung 1989). They become risk averse when the reference point is the project budget. When project managers are permitted to view a project in reference to the asset base of the organization, they become more willing to assume risk since their management has also shared the ownership of the risk (Cialdini 1993).

Prospect Theory

In 1979 Tversky and Kahneman proposed an alternative to utility theory. Prospect theory asserts that people make predictably irrational decisions. Rational choices should satisfy some elementary requirements of consistency and coherence (Tversky & Kahneman 1981). The way that a choice of decisions is presented can sway a person to choose the less rational decision from a set of options. The presentation of the problem is known as framing. Prospect theory demonstrates that the prospect of a loss will cause a person to assume a risk more than a commensurate potential gain.

The above risk propensity example demonstrates the effect of prospect theory. The risk averse person rejects the actuarially superior gamble in exchange for a sure gain. The risk taker rejects the actuarially better sure loss in exchange for a larger probable loss.

If the proposal for a new project is posed as a chance to eliminate a loss of market share it may have a greater chance of being approved versus a frame of opportunity to gain market share. Prospect theory addresses the illusion of scarcity inducing people to take immediate action. A frame that causes a prospect to believe that a loss is eminent if action is not taken is more likely to consummate the desired action. The illusion will induce some people to assume the risk.

People may become risk averse because they equate a loss as an acknowledgment that they have made an error. There is a tendency to view the prior decision in a frame that includes the new information as though the information had existed at the time the original decision had been made. A study that was conducted at Stanford University demonstrated that where subjects were given sufficient information regarding a trial. One group was given more detail regarding the defendant and another group was given additional information regarding the plaintiff. Although the groups knew the data was biased, they were unable to mentally balance the information. The biased groups were more confident about the outcome in favor of the side whose information was more voluminous than the group with balanced information (Kahneman & Tversky 1995).

Once a problem is clearly and reasonably presented, rarely does a person think outside the bounds of the frame. When a person perceives he is in a situation that offers little chance of gain and great chance of loss, people tend to take risks to hold the status quo, even when the expectation is that a larger loss is anticipated. There is a general perception that acceptance of a medium sized loss is an admission of defeat (MacCrimmon & Wehrung 1989).

When an option is compared to a reference point, future options are weighted for the advantages and disadvantages relative to the reference point. In a project context the reference point is often a baseline for cost, schedule, or functionality of the product. When the reference point is the status quo, the reference point is favored in context of potential changes. The fundamental lesson for the project manager is that care must be taken when a decision is made to freeze the baseline.

It is not how rich you are that motivates the decision. The motivation is whether the decision will make you richer or poorer. Change the reference point and change the results.

A good mediator will present a problem to one party in a frame that causes the person to believe that continuance of the position will result in a loss. The opposing party is then presented with another frame in which that party is presented as the loser. The two parties then compromise on a position where each believes that the resultant losses are minimized.

The knowledge of how to frame a question can differentiate between a good negotiation and a bad negotiation. If the position is posed as a potential loss for the other side there is a tendency for the other party to relinquish part of their position or act more rapidly. This is the sales strategy, “act today before the offer is repealed.” The customer fears loss of the opportunity.

Prospect theory holds that punishment of an undesirable action is more likely to lead to compliance and improved behavior while reward is more likely to result in degradation of behavior. The result is that a person is rewarded for punishing others and punished for offering rewards.

Mental Accounting

There is a propensity to invest more in order to bring the goal of the initial investment to fruition. This is especially true once we have irreversibly made the investment.

From the project perspective this translates into an unwillingness to ignore sunk costs when we are making a go/no-go decision.

People tend to view each risk as an independent event when weighting the decision whether to accept a project risk. Rather than accepting risks that consistently have a success probability in excess of 50%, we seek to enter into those events that have probabilities in excess of perhaps 90%. Hundreds of decisions are made during the tenure of a project. Statistically the project manager who is willing to accept actions that have a greater than even chance of success will show success. When decisions are made or actions are evaluated solely in terms of the specific outcome, without reference to prior gambles, the interaction with other decisions is lost.

A perceived change for the worse may be modified if the change is framed as an uncompensated loss or a cost incurred to achieve a benefit.

Fear of Regret

Regret may be viewed as frustration over an action that has either been taken with a result that is less than expected or failure to act where a positive result would have occurred. Regret is often a result of imagination or speculation regarding information that was not available at the time the decision was made.

Fear of regret causes managers to follow standard operating procedures. Project managers fail to engage in new endeavors due to lack of confidence and perceived retribution if the venture fails to produce the desired results. In the event that the project does not go according to plan it is easier to associate the failure with the standard procedures. A risk of violating the standard procedures may cause senior management to associate the innovative techniques used by the project manager with the less than expected results. Following standard procedures is less likely to lead to regret than the use of innovative techniques.

A means of reduction of regret when new techniques are used is to mitigate the risk by obtaining buy-in from senior management. The risk is then shared within the organization. Sharing of risk has been shown as a successful method of risk assumption.

Availability Heuristic

The availability heuristic is the ability to recall past data that is similar to the current situation. A bias may be induced by the past occurrence of low probability events that appear more likely due to the great impact of the event. A result is that the project manager makes a poor decision for the present project by rejecting an advantageous choice. Alternatively, the project manager may underweight the probability of highly probable events due to the lack of occurrence of the events in past projects.

Karl Popper presented a position that the proper method of scientific discovery is to refute the hypothesis rather than confirm the hypothesis. This is also the basis of testing. That is to discover the risks or defects rather than attempt to prove that they do not exist. Once a person becomes convinced that a positive relationship exists between events, the person will be able to find additional confirmation of the effect, even when shown the relationship is illusory (Piattelli-Palmarini 1994.)

A tendency may exist for the project manager to extrapolate from too few data points or to ignore the familiar occurrences in favor of the anomaly. Familiarity may also cause oversight. It is easier for us to accept those risks with which we are unfamiliar. We must also be careful not to assume that which is unfamiliar is in fact a risk. Knowledge of the ultimate outcome of events distorts a person's judgment when evaluating the decision that led to the outcome. People tend to heavily weight data that sustains the ultimate outcome and lower the weight on data that is contradictory with the outcome. The analyst tends to conclude that the decision was a mistake if the consequences are adverse to the intent (Redelmeier 1993). Redelmeier demonstrated that people are prone to err when decisions are made for long-term outcomes. Preferences change over time. There is no correlation between predicted future preferences and actual future preferences. Project decisions that are evaluated in post-project reviews are evaluated with a bias to current preferences rather than through reference to preferences that existed when the decision was made.

Negotiation

Project managers must be good negotiators. Negotiation invokes substantial risk if it is not performed well. An important aspect of negotiation is fairness. People tend to view concessions that are made by the other side as less valuable than those that are made by one's own side. If the recipient of information views the source of the information in an unfavorable manner, or if the information is perceived as being freely available, the value of the information is lessened (Mnookin & Ross 1995). An inordinately high weight is placed on a commodity or opportunity that is denied versus that which is available (Ross 1995; Cialdini 1993). In order to increase the position of a negotiation, the project manager may want to elicit the other party's values and preferences before making concessions then link the proposal to their preferences. Possible concessions may be offered so that the other side may select the one that is most favorable.

Studies have demonstrated that where a negative relationship exists between parties or where a close positive relationship exists the negotiation will suffer (Bazerman & Neale 1995). The effect of a close relationship the other party will demand less and offer more resulting in lower rejection rates. The preservation of the relationship supercedes the desire for a Pareto efficient result. The offer tends to be from an equity position where the offeree demands less than equity. When negative relationship exists the parties are willing to risk disadvantageous inequity in order to maximize their own expected gain and increase the likelihood of obtaining positively valued advantageous inequity.

The result of the studies is that while a project manager must establish positive relationships with the parties with whom negotiations will take place, negations with friends and close relations are best avoided.

Estimating Overconfidence

A substantial risk occurs when project managers are given an arbitrary date for completion of a project. A tenbdency exists for project managers to view their ability as superior to the overall industry norms. Extrapolations are made for current achievements based upon an assessment of the relative strength of causal factors. Without historical data from which to draw, the resultant estimate may produce an inconsistency between the estimator's overall beliefs and the belief about the current situation.

Since project managers do not plan for failure, the result of taking a date and adding additional time to allocate for risk and uncertainty in fact causes the estimator to ignore the potential uncertainties. Rather than performing a proper risk analysis, specific risks undiscovered in favor for a padding number. The end result is over optimism and excessive risk taking when the goals are established. Since managers tend to be risk averse (MacCrimmon & Wehrung 1989; Tversky & Kahneman 1995),a paradox lends to denial of risk where the decision-maker assumes unwanted risks.

Project managers tend to exaggerate their ability to control their environment. They bet on their estimate of their skills rather than a true examination of the actuarial probability of the success of an event. After the baselines have been established and plans have been written, unrealistic optimism sets in and favors excessive risk taking (Cialdini 1993).

Conclusion

Psychological factors weigh against the project manager from making logical decisions when deciding on whether to accept project risks. The successful project manager must be willing to view a problem from many perspectives to avoid biases induced by availability of prior information and the need for appearance of making correct decisions.

Project managers must be willing to accept calculated risks in order to progress within the organization. A tool that is used to know which risks to accept is gathering sufficient information so that the risks can be properly evaluated. A risk exists that if the project manager obtains too much information, a decision will be deferred or referred to others. When indecision occurs, the project manager may look to the actions of other project managers of people in the industry in order to emulate their actions.

In order to assume larger risks, project managers may need to enlist the buy-in from senior management. Project managers tend to view the project's budget as personal money rather than in the context of the organization. Obtaining commitment from senior management may help to share the project risk.