A quick and dirty test for optimism bias

OPTIMISM BIAS - FINANCIAL MODELLING EXPERTS

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Daniel Prinsloo

Published:

04 Sep 2014

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Projects frequently come in at over twice the initial estimated cost while taking twice as long as expected to complete construction – these range from Oil & Gas and Mining, to the Olympic Games.

Why is there such a big discrepancy between the actual cost, and the assumptions used for the economic and financial analysis that was presented to the board for approval?

Are these teams not undertaking any up-front risk assessment?

Even if risk assessments are undertaken, and in big projects this is very often the case; project teams are inevitably taking the “inside view” and demonstrating “optimism bias” as described in Daniel Kahneman’s wonderful book “Thinking Fast and Slow”.

How then can we, as project modellers, get comfort that the risk analysis has been factored into the base case assumptions?

Over the years that we have been developing models, we have had many challenging and interesting discussions about the uncertainty around input assumptions used in models.

One good question to ask a project team is “What needs to change or what can the team do to reduce cost and / or improve the schedule given the scope?”

This may seem like a trivial question but it’s actually very effective.

If the team struggles to provide a concrete list then, most likely, the cost and schedule are optimistic i.e. the base case already assumes the best case assumptions.

A second method is to take the “outside view”.  Ask “What have similar sized projects cost in the past” and “How long did they take to complete construction?”.

If you get an answer along the lines of “much longer and more costly, but our project is different / our team is better / we have learned from others’ mistakes”, be afraid. Be very afraid!

Do you have other good tests that help you quickly assess the quality of assumptions?

Look out for our eBook on how to approach risk modelling – expected later this year.

 

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Daniel Prinsloo
Daniel is no longer with F1F9 but we really like this blog so we have kept it.