Why You Will Ignore Opportunity Cost in 2018 Too
As the saying goes, change is the only constant. All the companies that I work with want the change, either because of fear of being disrupted or because of the opportunities that disrupting their industry bring. This is at least what companies and their employees tell me. In practice, however, I run into situation after situation where people are trying to slow change down. Many try to keep today as it has always been with the promise of changing tomorrow.
Psychology, of course, provides explanations of why this is the case: humans, on average, fear losing something they have today about three times as much as they appreciate gaining something. So, as a company, losing out on today’s revenue based on historical business models because of some high-risk experiment that would inform the future and perhaps create new revenue opportunities is very difficult to realize. In practice, we give up “guaranteed” revenue now for the promise of new revenue in the future.
Once you take that perspective, you see examples of this problem everywhere. Especially in regulatory frameworks and certification processes, the current state is only allowed to change very slowly and after very deliberate and extensive evaluation of the intended change. The argument always is concerned with avoiding the risks that come with implementing changes. Three quick examples:
- In automotive, many express concern about the risks of self-driving, autonomous cars. Everyone is scared of an autonomous car causing some horrific accident because of lack of testing and improvement. However, interestingly very few people are concerned with the traffic deaths caused by human drivers. According to Wikipedia, in 2016 alone close to 40 thousand people died in traffic accidents, just in the US. Assuming that autonomous cars can reduce this number with 75% (a conservative estimate, I believe), delaying the introduction of autonomous cars with three years because of conservative attitudes in OEMs and certification institutes will result in almost 100 thousand unnecessary deaths (again, only the US!).
- In the medical space, certification institutes like the FDA are notoriously slow in approving new medicines and treatments. It can literally take decades for approval processes to be completed. And I know that in medicine, there is a lot of controversy around the data generated by medical trials and there are many in the industry that view patients and their insurance companies from the perspective of revenue maximization. However, I am also convinced that the vast majority of people working in healthcare do so from a genuine desire to do good. Similar to autonomous cars, I can’t help wonder how many people have died unnecessarily because treatments being approved too late to help them. And how does this compare to people that have died because of novel treatments that proved to have severe negative side effects? Unless I have data to the contrary, I believe that the number of unnecessary deaths due to slow approval processes outweighs the number of people that died because of risky treatments with orders of magnitude. And let’s not forget that only in the US, every year more than 400.000 people die because of preventable medical errors. And this is an industry that has been notoriously slow and conservative in adopting new technology and approaches.
- In all industries building safety-critical systems, safety certification is a process that is entirely based on waterfall processes. You finish the development of a new system, establish safety through a combination of testing and hazard analysis, convince the certification institute that you’ve done a good job, get the stamp of approval and start manufacturing. The problem is that any change to the system triggers, in principle, a complete redo of the safety assessment. The problem is that that the cost of recertifying is so large that companies leave known safety hazards in the system. In general, many other areas of improvement are ignored. That means that in automotive, medical, aeronautics, trains and shipping as well as many other industries, the systems are performing suboptimally and causing preventable damage and deaths due to slow, expensive certification processes.
Although these examples are concerned with certification and safety-critical systems, it is the underlying mindset that I care about. Whenever confronted with risk, humans have a tendency to glorify the current state and exaggerate the risks associated with change. We have a tendency to ignore the opportunity cost of our inaction.
In industry, some companies have realized this problem and put systems in place to counterbalance this basic human tendency. For instance, combining the 70/20/10 innovation model with the three horizons model offers a system to ensure that new innovations receive sufficient funding. The three horizons model, as the name indicates, categorizes the businesses that the company is concerned with into three buckets. Horizon 1 are the businesses that are large, successful and the cash cows of the company. Horizon 2 businesses are proven, but still smaller and growing rapidly. Horizon 3 businesses are experiments that may become future horizon 2 and horizon 1 businesses. The 70/20/10 model then allocates resources to the three horizons as indicated: 70% of resources are allocated to horizon 1 businesses, 20% to horizon 2 and 10% to horizon 3. That system ensures that companies invest enough in creating new businesses that, typically, capitalize on the new opportunities that the organization otherwise might have ignored.
The 70/20/10 model is a mechanism explicitly intended to avoid falling into the opportunity cost trap, but of course it is rigid and not concerned with context and opportunity per se. It just focuses on effort allocation and as I wrote about in earlier blog posts (like here), it may easily result in low risk/low reward innovations receiving the 10% of resources.
As individuals, we need to build systems for ourselves as well to ensure that we don’t fall into the opportunity cost trap. Although it’s tempting to focus on willpower as a way to ensure that we proactively embrace what we experience as a risky future, most of us have learned that willpower is a limited resource that you run out of rapidly. Instead, building systems that, over time, rely on our habits is a much better mechanism to avoid the opportunity cost trap.
Concretely, there are at least three mechanisms that I have used with, I think, some success:
- Remember that you’re going to die: In his 2005 commencement speech at Stanford University, Steve Jobs reminds us that our time on this planet is limited and that we need to use it to live our own lives to the fullest. In his words: “You are already naked; there is no reason not to follow your heart.”
- Imagine the worst that can happen: The Stoics employ a daily practice where you are asked to imagine the worst scenarios that could happen to you. This prepares you for the loss that undoubtedly will happen. Using this practice for the changes that you’re looking to make in your life helps you visualize the fears associated with the change. And by making them more concrete and assessing how difficult it would be to recover from these worst case scenarios, you can get a handle on your instinctive fear of change. In his TED talk, Tim Ferris introduces the notion of fear setting as a tool to manage irrational fears of change.
- Visualize your life in a decade: Finally, try to visualize what you want your life to look like 10 years from now. Once you have established this vision, the next step is to analyze what you need to now, in a quarter and in a year to bring that future about. This can help overcome the emotional resistance by using the rational mind.
Concluding, it’s the start of 2018 and we have another fantastic year ahead of us. Rather than staying stuck in our day to day motions, I challenge all of you to follow your dreams and become cognizant of the opportunity cost associated with inaction. Both companies and individuals suffer from ignoring opportunity cost. I believe that making opportunity cost explicit and quantifying what the risks and costs of not changing will make you take the right action. And that, in the end, will lead to a better you, better companies and a better society. As the Swedes say, god forsättning!