Companies want innovation but do everything to stop it from happening. This paradox is one that puzzles everyone. We desire it so much for us and admire companies that are innovative, but our actions do the exact opposite. Why is that so? Behavioral Economist Richard Thaler gives some clues in his new book Misbehaving through an interesting example that perfectly demonstrates why corporate innovation efforts are often leading nowhere.

Portfolio vs. Single Projects

In a meeting with 23 executives plus the CEO of a profitable company in the print media industry, Thaler put them through this scenario:

Suppose you were offered an investment opportunity for your division (each executive headed an independent division) that will yield one of to 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. Thaler then asked by a show of hands who of the executives would take on this project. Of the twenty-three executives, only three said they would do it.

Then Thaler asked the CEO a question. If these projects were “independent” – that is, the success of one was unrelated to the success of another – how many of the projects would he want to undertake? His answer: all of them! By taking on twenty0three projects, the firm expects to make $11.5 million (since each of them is worth an expected  half million), and a bit of mathematics reveals that the chance of losing any money overall is less than 5%.

The responses of the executives and the CEO indicated an underlying problem. Either the managers were wimpy and unwilling to take risks, or the incentive system was not rewarding this sort of risk taking.

The managers explained that a successful project may get them a pat on the back or a maximum bonus of up to three monthly salaries, while failing with the project makes the lose their job.

Looking from a portfolio perspective it’s clear that all 23 projects should be done. Even if some fail, the majority will succeed and the whole portfolio will make the company money. Like a venture capitalist who invests in many startup where the majority will fail but one or more will be tremendously successful and cover for the losses of the other investments.

Narrow Framing

While the rational perspective is to see the 23 projects as a wholesome portfolio, what happens is what is called the narrow framing. When each individual project is consider narrowly one at a time, then managers will be unwilling to take the risk. The company ends up taking on too little risk.

Dumb Principal

In scientific research the principal-agent problem often describes the relationship and reason for behaviors. The agent (in our case the executives) is given options and could be blamed for not having the overall good of the company in sight, but only his own benefit. But this would be short sighted in that example, as the agent is punished in case he fails. that’s why he is set up to avoid losses and behave risk-averse.

But it’s not the agent who is to blame, but the principal (the CEO). He has set up the executives not to maximize the profit for the firm, but to minimize the risk for each individual project. The incentive system the principal set up reinforces that. This is a dumb principal situation.

Even if a manager takes on such a project, the fear of failure can lead to reporting the real situation falsely and effectively destroying a trust relationship between agent and principal. A simple example is the one between a parent and her child. A parent wants to have her child behave and a trusting relationship. We want the children come to us when there is a problem and fell safe telling us that. But as soon as we introduce an incentive system, we set the relationship up to destroy the trust. Imagine you told your child when she behaves she will get ice cream for dessert. But now she misbehaved at the playground but hides the fact from you. Because you as the principal will punish her by not giving her the ice cream. You set her effectively up to lie to you.

In companies this is equivalent with hiding problems in the project and go on as long as possible hoping that the situation will somehow go away. At stake is your bonus that the very same principal who wants you to come to him and tell him about the problem will withdraw when he realizes that you are not doing a good job with your project.

Hindsight Bias

Why does this happen? When a project fails and a postmortem  is done decisions that have been taken during the project in hindsight may look stupid. At the time they were taken, this was not clear and this is often the case. This is what is called the hindsight bias. The agent is blamed for not having been able to predict that at the time, but looking at it form an ex post perspective may look always logical and everyone is puzzled why this wasn’t know before. The conclusion often is that this must be the fault of the dumb agent. So the manager responsible for the project gets punished.

Conclusion

And this explains exactly why nobody wants to take on or support innovation projects in corporations. Innovation is not framed as a portfolio of innovation projects, but each project is framed narrowly. Managers who take on these projects try to avoid anything that can be risky, so not enough risk is taken to really create breakthrough innovation – and enough of them.

The message that punishing managers of failed projects gives to the rest of the company is to avoid risks at all costs. From a hindsight perspective decisions taken in a failed project always look dumb, but this is hindsight bias that management has to be aware of. Without an incentive system that aims at maximizing the company’s overall benefit – which means that both managers of successful AND failed projects must be rewarded – a company is ruining its innovation efforts and diminishing its profit.