In his book Misbehaving, Richard H. Thaler tells an interesting story. In a class on decision-making to a group of executives from a company in the print media industry, Thaler puts the executives to a scenario: Suppose you were offered an investment opportunity for your division that will yield one of two payoffs. After the investment is made, there is a 50% chance it will make a profit of $2 million, and a 50% chance it will lose $1 million. When Thaler asked who would take on this project, only three of twenty-three executives would do it. Then he asked the CEO how many of the projects would he want to undertake (suppose all projects were independent, that is the success of one was unrelated to others), the answer is all of them!

Both the CEO and executives were rational. By taking on the 23 projects, the firm expects to make $11.5 million. In fact, a bit of mathematics shows that the chance of losing any money overall is less than 5%. It is a no-brainer for the CEO to take all the projects. On the other hand, a manager who wouldn’t undertake the project said that if the project was a success, he would probably get a pat on the back and possibly a bonus, say three months’ income. But if the project failed, he thought there would be decent chance he would be fired.

risk-averse

This story beautifully illustrates why some companies are not innovative (enough): the lack of an environment in which employees feel that they can take good risks and not be punished if the risks fail to pay off.

What Thaler didn’t mention is how hard to create such an environment. In order to encourage the managers to take good risks, CEOs often have big bets and starts high profile projects. Although some big bets (e.g. Boeing 747 and IBM System 360) had great results, many projects that start big unfortunately fail big, which is especially true in the software world. All long time successful software projects such as Unix, C, WWW, MapReduce, etc. started with only one or two engineers. And there are tons of miserable large software projects. A recent example is Google+, which suddenly became a project with thousand engineers overnight.

sunk-cost

Although many big bets are doomed to fail, crafty executives will take on them. These smart guys know sunk cost fallacy and how to play with it. When a big bet goes off the track and some peoples start whining “We are f***ed up!”, millions dollars have been poured into the project. Giving up is simply not an option in many corporates given the huge sunk costs. With a “can-do” attitude, the company will keep investing and hopes to save the project. Note that the leading executive had very likely been promoted before this point. Even if the project be a total failure, s/he can easily find a new high-profile job in another company with a resume of managing hundreds employees and million dollars budget. S/he really has nothing to lose and would like very much to take the risk (well the risk is of company, not his).

Don’t make big bets. Let a thousand flowers bloom. Let gardeners know that this is a learning process and no one will be punished if a flower doesn’t bloom.

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