What are your chances of a successful project?
It’s Sunday afternoon, and I’m sitting in a coffee shop typing this article. My youngest son is at a birthday celebration and my eldest is sitting opposite me doing his school homework. (Although he was bribed by millionaire shortbread, he is still doing it).
I am currently rereading “Thinking, Fast and Slow”1 by Daniel Kahneman1 and am reading the section that describes his famous Prospect Theory2 (about making decision under risk) and how it differs to classic Utility Theory3. I also remember how Daniel Kahneman (his long-term friend and collaborator) used to spend hours discussing their ideas in restaurants.
While I am not yet a scholar, I do have some knowledge. While I am not (yet!) a scholar in Prospect Theory or Utility Theory, I am able to discuss them with my oldest son.
I will (attempt) to explain Prospect Theory and Utility Theory, then discuss how these can be applied to projects. It’s possible to grab a coffee and a chocolate hobnob before you start the journey.
Before we get to the topic of this article, I need to explain Prospect Theory and Utility Theory as I understand it. I will be focusing on three principles.
My explanations and examples are taken directly from the book. I would like to also say that I am not responsible for any misunderstandings, omissions or incorrect interpretations. All explanations in this post are my own.
Utility can be defined as the “relationship between psychological value or desirability and the actual amount money”. Professor Kahneman continues to state that utility theory (i.e. Professor Kahneman continues to say that utility theory (i.e., the psychological value or desire for money) of a gain can be assessed by comparing two states of wealth.
The utility of gaining $500 on your wealth $1m is determined by the difference in utility between $1,000,500 or $1m (the two states being $1m and $1,000,000.500).
The ‘disutility’ of losing $500 if you have a larger amount is the difference between PS1m or $999,500 (the two states are PS1m or $999,500).
Professor Kahneman continues to discuss the fact that utility theory cannot be used to show that the ‘disutility of a loss can be greater than that of winning the same amount. The psychological value (or desire for money) – i.e. Utility) will be different depending on whether you have $1,000,000.500 (a gain), or $999.500 (a loss).
Professor Kahneman explained that you don’t need to know the state of wealth (as mentioned above) in order to determine its utility. However, this is too simple and doesn’t have a’moving portion’: the reference point, the ‘earlier condition relative to which gains or losses are evaluated’.
Better outcomes than the reference point are considered gains and those below the reference points are considered losses. Prospect Theory is based on this principle: You need to know the reference points.
Prospect Theory also advocates a decrease in sensitivity when evaluating changes in wealth. This is an example of Prospect Theory. The subjective difference between $900 & $1000 is smaller than between $100 & $200.
Professor Kahneman explains it (rather eloquently) by explaining that turning on a weak lamp has a large effect when it is in dimly lit rooms, but the same amount of light can be undetectable if it is brightly lit.
Prospect Theory’s final principle states that our psychological response to loss is stronger than our (psychologically) response to corresponding gains. This is known as Loss Aversion. Imagine tossing a coin.
If it lands on head, you win $150. If it lands in tails, you lose $100. These are the terms of the toss. Would you agree to a wager?