Summer is for relaxing, but also for reading books in more depth. During his vacation Bengt Järrehult read Daniel Kahneman’s book Thinking Fast and Slow for the second time and more thoroughly. Here are Bengt’s thoughts on how Prospect Theory applies to innovation related decisions – the decisions that may seem stupid and irrational – but are they really?

In the process of making a decision we usually try to be rational and follow probability, but we are fooled by what Kahneman calls System 1, or as we earlier (but mistakenly) called the Right Brain – the fast, emotional and irrational part involving some of the deeper and older parts of the brain. If the other part of the brain, Kahneman’s System 2, were in charge we would of course follow what is called the “Rational Utility Line” which is the red straight line where the Probability is mirrored 1:1 by a logical Decision Weight. However, in reality we tend to follow the blue Irrational Utility Curve! The left brain/System 2 is not as dominant as we think.

Figure 1: Decision Weights vs. Probability

For more information about the book, please visit: Thinking Fast and Slow

We are fooled by the near extremes as we consistently overestimate the probability of unlikely events and even more underestimate the probability of highly likely events. Let me explain this in 4 examples as in Fig 2:

Figure 2: Risk behavior regarding Gains and Losses at High and Low Probability

A. Chance to win €1 million in a lottery is very low, still you take a decision to buy a ticket.

B. Risk that your house may burn down is very low, still you take a decision to buy a fire insurance.

C. Chance to win as plaintiff in a court case on €1 million seems to be almost certain, still you agree to settle at €0.8 million.

D. Risk that you are about to get bankrupt on the casino evening is very high. Still you take a large short-term loan from the mafia and bet all on number zero on the roulette.

In example A you pay a minor fee for the fun of having your dreams (but remember that the probability of being struck by lightning is usually higher than winning the top gain in a lottery). In examples B and C you gain the certainty you want, but to a minor cost. Case D is special though! This is the case where you may act really foolishly. When you are faced with the threat of a major loss, your brain may go berserk when the left part of it shuts down. You spend all the money you have left, sometimes you even borrow money, to take a big risk that most likely will only make things worse – but IF you would be unlikely lucky, the seemingly unavoidable loss could disappear.

Transferred to the innovation world, the four examples could look something like this:

A. Low probability of a gain: You discover something really wild and crazy, that If it would succeed would be disruptive to the whole industry. This is really OK if you start to bet at low costs, but you’d better be careful with the evaluation factors if you want to succeed in larger scale. This IS a lottery! And it is fun!

B. Low probability of a loss: You have started your business and it works really well, however, you never know what the future will bring you so just in case you sell part of your business to mitigate the effect of future losses – IF they would occur. Do you really have to?

C. High probability of a gain: You are in the expansion phase of your venture, but you are tight on cash. Hence – just for safety – you sell some of your delayed invoices to a financial institution for 70-80 % of their nominal value just to get outstanding money in on time. Is that the right thing to do? Could you do it in a better way?

D. High probability of a loss: Kahneman’s book takes up an example where 47 % of entrepreneurs in “doomed” ventures, i.e. an external auditor have told them they are sitting on “dead ducks”…ignored the advice to stop what they were doing and instead they increased their efforts to succeed! But is this not the essence of having entrepreneurs, without which we all would swim in red oceans only pursuing predictably boring stuff?

Doing what is rational is usually good, but if we only would be rational we would miss out on many of the “Black Swans”. The trick is to strike the appropriate balance between the few expensive rational decisions we need to take and the inexpensive, but plentiful, irrational decisions that we take more on a gut feeling. Remember that the amount of unlikely events is so unlikely large, so the unlikely is rather likely.

By Bengt Järrehult

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About the author

Bengt Järrehult is Fellow Scientist Innovation at SCA, a global hygiene products and paper company. He is also adjunct professor and visiting professor resp. at 2 departments of Lund University in Sweden. He is an avid reader of and presenter on the topics of innovation, especially on breakthrough innovation and the psychological hurdles that exist to achieve this, hurdles that we may or may not be aware of. He is of the opinion that most companies more or less know what to do to become more innovative. What they don’t know is what really hinders them from doing these measures…

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