People say that money changes everything. But what they should say is that money changes people. In the world of economics, there’s a theory that informs how people make decisions – and what factors influence those decisions. It’s called behavioral economics, and it looks at the psychological, social, cognitive and emotional factors on the economic decisions of individuals and institutions.
Behavioral economists have discovered that people have biases that can prevent them from making the best decision possible. Armed with knowledge of the subtleties involved in how people make decisions, project leaders can manage risks and successfully maneuver the make-or-break points in the successful management of a project.
So how can we help our project team members to make the best decisions? Behavioral Economic theory can be applied directly to project management through several of its key ideas around decision-making: loss aversion, sunk costs and endowment effect.
Loss aversion is just a fancy way of stating that human beings tend to prefer avoiding losses over gaining something. Or, as basketball great Larry Bird put it: “I hate to lose more than I like to win.”
But how exactly does it work? Well, to give you an example, there was a study in which participants were first broken down into two groups. Each group was given $50. One group was given a choice between keeping $30 or taking a 50/50 chance of keeping all the money by flipping a coin. The other group were given the choice to give back $20 or flip a coin to keep all of the money.
You’ll have noticed that both groups were given the same choice, the only difference is that one was told they could keep a percentage of the money while the other was told they had to give back some of the money. The amount, of course, was the same. However, the results of the study were very different.
In the first group, 43% decided to gamble, while 61% of the second group decided to gamble. The way you pose your situation influences the decision made. People prefer to keep $30 then lose $20—even if it is the exact same thing!
The lesson for project management is simple: Whenever there’s a decision to make, make sure you state all the options available using the same perspective. Who knows, you may be surprised that some of the options you identified are in fact the same!
Think about how the above example applies to sunk costs on a project. If $50 can influence a person, then a budget a few thousands times that figure is sure to play havoc with clear decision making. Imagine you’ve spent your entire project budget of $100,000. Now you’re faced with the option of continuing the project to conclusion with an extra $50,000 cost – or killing it.
If you invest in completing the project, there’s a projected return of $60,000, but if you kill it now you’ll get back $20,000. For some, the $100,000 already spent makes this decision so difficult.
But don’t be distracted. Look at the financial facts: if the project is concluded you’ll make a profit of $10,000, but you’ll earn twice that number to kill the project.
In this light, killing the project is your best decision. The fact that the budget was already spent should have no influence on this decision because it impacts both scenarios just the same: whether you continue the project or you kill it, you have already spent $100,000.
This sunk cost example was about money but all too often there are costs involved other than money. Examples of those can be reputation or comfort. And people find it even harder to deal with something like reputation, which is next to impossible to measure objectively. Compare to these, dealing with money in sunk costs is pretty easy – at least money is easy to measure objectively.
The endowment effect refers to giving a product or service extra-value just because it’s yours. Sales and marketing know all about this and they often explore it. For example, there are two similar chairs, one costs $100 and the other costs $120, but with a 30-day money back guarantee. Most will choose the more expensive chair because of the return policy. It’s like insurance, paying a bit more for peace of mind.
But the truth is that you’re unlikely to return the chair unless there’s something critically wrong with the product. Once you have the chair, once you own it, you’ll find it hard to let it go – you’d feel like losing it and you really don’t want to feel like losing. The extra money paid is how the seller added value to the product and in so doing made it more attractive to the buyer.
This endowment effect can explain why it can be difficult to see our own projects clearly. There’s always a reasonable explanation to the mistakes we make, and our project team is always better than any other because we’ve added value to the project due to our involvement. That can obscure our constructive decision making.
How to Safeguard Your Project?
If you think that stating the facts and being objective allows you to make the best decisions possible, behavioral economics shows you that you’re dead wrong. So what can you do about human nature?
I’m afraid there’s no quick fix, but there are some basic reminders:
- People Aren’t Always Objective. Objective information, hard data and numbers are necessary to support your presentation, but you have to speak to people on an emotional, instinctual level to fully reach them.
- How You Phrase Options Can Affect Decision-Making. Loss aversion is only one of many biases we are all subject to. What can you do to get around these biases? When you have a decision to make with your team, the easiest thing to do is to state all of the options using the same perspective, as noted above in loss aversion. Don’t describe an options as losing something and another one as getting something back when you phrase them both under the same perspective. The way you phrase options to your team can inform how they make their best decisions.
- You Are Biased, Too! Know that you share these behavioral responses, too, and the hardest part of your job may be parsing out your own inherent prejudices so that they don’t negatively influence your decision-making process.
Please note that Behavioral Economics is not an exact science and there are always many factors influencing why people respond they way they do. The general point, however, remains: even when we’re quite sure we’re being objective, we are influenced by responses beyond our conscious control.
Get your team involved in the discussions above! You can introduce the concepts of Behavioral Economics when your team is defining risks at the start of a project or collaborate openly throughout the project lifecycle to involve the group to be mindful of the inherent project risks associated with our human behavioral tendencies.
Using a flexible planning and collaboration tool like ProjectManager.com can support team discussions, promote clarity of goals and help identify risks early on the project. Start a free trial today.