Posts Tagged ‘prospect theory’

Risks and innovation

January 19, 2014

In 1979, Daniel Kahneman and Amos Tversky won the Nobel Prize for Economics for their “Prospect Theory: An Analysis of Decision under Risk”.

This theory shows that we prefer certainty to taking a risk. We see this on auction sites where the “Buy It Now” price is often much higher than the price of similar items sold by auctions. The BIN price may influence the bidding but it is for those of us who are willing to pay more for certainty.

Stable, well-established organizations tend to be risk averse. They place great value on their stability and choose continual improvement instead of innovating. Indeed, most organizations with process-based management systems continually improve their goods, services and processes. Some also go beyond development to design something entirely new.

Sustainable organizations do both; they continually improve and they innovate to find new ways of fulfilling their missions.

Successfully managing risk implies formal largely predicable processes. Being innovative tells us that selected team members interact in an informal free-thinking “sandbox” of collaborative effort. How do process-based organizational management systems help their leaders to manage innovation and the risks inherent to innovation?

First, let us never forget that effective process-based management systems deliver a valuable resource: time. By preventing problems, the management system substantially reduces time wasted on firefighting. The organization has time to innovate. Secondly, remember the leaders who serve to lead. Such leaders remove causes of fear from their systems. Their words and actions earn trust by selflessly taking responsibility for helping employees to understand and fulfill stakeholder needs. In this supportive environment, noble causes can stimulate innovation to find new ways of creating successful stakeholders.

The leader challenges and authorizes the special innovation team that comprises accomplished problem solvers. Unlike capable processes, innovating requires the leader’s patience and to expect to “fail” many times. Of course, knowing what does not work is not really a failure. And so-called failures may be successful in completely unexpected ways. Think Post It Note®.

Innovative teams comprise a mixture of different types of people with a wide variety of talents. Instead of endlessly talking, the team creates prototypes as soon as possible. Prototyping a new service may require a focus group. The team allows for the fact that focus groups usually comprise people who favor certainty. The prototype must impart value by solving a costly problem.

A shared understanding of the costly problem is a vital input to innovating. In bringing the innovation to market (internally or externally), successful organizations decide which innovations yield the greatest benefit to stakeholders. They determine which innovations have the greatest chance of success. The latter stages of innovating show that innovating is a process that really is design rather than development. It is a process that includes such risk assessment techniques as SMEA (Success Modes and Effects Analysis) and FMEA (Failure Modes and Effects Analysis) before verifying and then validating the design.

Of course, risk has an upside. Nevertheless, risk managers tend to manage risk to avoid loss instead of managing risk to add value. Prospect Theory can help them to understand this. By fully appreciating risk, we recognize and manage both the downside and the upside of our decisions including our decisions to innovate.

In responding to a recognized adverse risk or threat, we use our management system to avoid, accept, transfer and mitigate aspects of the threat. Similarly, we respond to a recognized positive risk or opportunity by using our management system to share, enhance, accept and realize the opportunity.

Knowing Kahneman and Tversky’s Prospect Theory, we can dissolve the fear that would otherwise stop us from making difficult investment decisions. Organizations can enjoy the thrill and rewards of innovation by recognizing the value of taking positive risks that are essential for sustainable organizations to create even more successful stakeholders.