Optimism bias, strategic misinterpretation and reference class forecasting

Multi-National corporations completing large-scale projects face potential high overruns and possible overestimations on initial budgets. Through these, sometimes unrealized setbacks, the corporations are not operating at maximum possible efficiency. This can happen through a number of factors such as a poor allocation of resources, lacking a sufficient standard of managerial skills, Optimism Bias and Strategic Misinterpretation.

A Danish geographer by name of Bent Flyvbjerg did extensive research into cost overrun and benefit shortfall of major projects, with additional studies into hypothetical solutions. Through his investigation, Flyvbjerg realised that the cost and benefit shortfall of major projects could be better understood by filtering the wide topic into two sub-topics, Optimism Bias and Strategic Misrepresentation. Through further analysis into the study area, a possible solution to this problem was first found through the use of the Reference Class Forecasting approach (RCF). RCF approach helps by providing a less skewed and opinionated view on a specific subject by using the 'Outside View' instead of the commonly applied 'Inside View'. The over-arching goal is to reduce cost overrun and benefit shortfall by engaging all aspects to increase forecasting accuracy[1].

Through reading this article, a clear and succinct explanation of the strategies and ideas mentioned above will be discussed. A brief analysis will be given on how it is used in business practice to increase efficiency and a detailed paragraph of the studies' limitations as a theory will also be covered.

Optimism Bias

Optimism bias by definition is a form of cognitive bias. This bias refers to the belief that there are reduced negative externalities about a specific situation[2]. Factors that contribute to Optimism bias is if an individual or corporation has a more informative view of the desired end state of the project, the cognitive mechanisms in use, the information the individual or company has to begin with and the overall mood of the project scope. All these factors significantly contribute to the bias, potentially skewing judgement on a project. Optimism bias can be both positive and negative, for example, an overoptimistic overall outcome of a project's benefits can lead to poor planning, budgeting and other factors in the early stages of the project portfolio. However, an increased Optimism Bias can be seen as quite a positive aspect of a business plan. An over-confidence in the desired outcome would increase expectations of an individual or company as it is falsely made to look that it is easier to achieve.

Although this sounds negative if not met, increased expectations help people in a corporation and the business its self, grow considerably as the company will continuously strive for potential new feats. Not only are potential higher target reached, but self-satisfaction is drastically increased no matter the outcome as noted by Psychologists Margaret Marshall and John Brown's theory of Optimism Bias presented by Associate Professor of Cognitive Neuroscience Tali Sharot in a TED talk [3]. The study found that when individuals succeed, they attribute their success to their personal traits. This increased satisfaction boosts continual drive for success, even with mishaps, the mentality of individuals has been changed to a higher level of output and thinking.

Reference Class Forecasting

Reference Class Forecasting (RCF) is a method of looking to future events by taking relatable situations and their previous outcomes. This approach aims to give a much less biased view on a specific event. A study conducted by Daniel Kahneman and Amos Tversky in 1979 shows that when a project is in its beginning stages, judgement of the overall risks of any given events in the project, the total cost and the length of time it will take to complete, is quite often biased, sometimes even without the intention of bias. This phenomenon is called 'The Planning Fallacy'.This sensation was further investigated also by 2002 Nobel Prize winner Daniel Kahneman. The bases of this experience is that without any real means of desire, humans have a tendency to underestimate the time and resources that you will need to achieve your goals, as a corporation or as an individual[4]. To put this into perspective, the construction of the Sydney Opera House in Australia was originally estimated to cost a grand total of $7.0 million. At the productions' end, the accumulated spending exceeded $102.0 million. On completion of the Sydney Opera House, the project not only surpassed its budget by approximately $90.0 million but it was over ten years over the initially predicted arrival date.

The investigation from Kahneman and Tversky proved that it is entirely the norm to have an unplanned Optimism bias about future events. It has to be also noted that the same study found the there had been deliberate bias towards costs of materials and labour as a company by previous project managers in an attempt to produce a lower final cost, lower than their opposing firms to ensure that the company would get the contract[5].

• Cognitive Bias
• Availability Biases

Confirmation Bias AGree/Disagree

The Planning Fallacy Inside/Outside view Distribution of information (S.D/Variance) Systematic fashion-RCF

In 2003, Kahneman completed another investigation on the benefits of using the 'Outside View' in Reference Class Forecasting rather than using the 'Inside View'. Taking the 'Inside View' instead is combining favouritism to an idea by having a tendency to tilt more to it therefore obviously incorporating Optimism bias to the situation and having inaccurate readings and forecasts as a result. Furthermore, Kahneman stated that the 'Outside View' attempts to limit the amount of confidence and assurance to a specific situation by targeting the narrowmindedness and aims to eliminate it.

Professor Bent Flyvberg, in 2007, constructed another detailed overview of Reference Class Forecasting and incorporating both the 'Outside View' and the 'Inside View'. In doing this, Flyvberg created a basic yet efficient system to also further eliminate the overconfidence present in the 'Inside Views' reasoning. The Reference Class Forecasting process three-step approach states that;

• It is critical to identify a Reference Class of a past similar project.

• Establishing a probability distribution for a selected Reference Class for the parameters that are being forecasted is vital.

• Comparing the specific project with the Reference Class distribution in order to establish the most likely outcome for the specific project is paramount for overall sufficiently accurate forecasting.

Setbacks of Reference Class Forecasting

Explaining inaccuracies Inaccuracies in forecasteing Cost Benefit Analysis wrong by several factos socio economic/enviro

time delays 

work breakdown structre

Business Practise

first refenece of RCf Berg?2006 (2004 uk gov edinburgh trams netherlands, Denmark, Switzerland all implented RCF

Limitations

https://www.youtube.com/watch?v=X9w9LTR-xSc

Alternatives

Socratic Method why?, 5 year old child State, question, redefine

References

1 [6]

2 [7]

3 [[8]]

4 [9]