Project selection is a difficult task for companies that own and manage projects. Technical concerns such as research and development, as well as commercial concerns such as competitors’ product launches, make it difficult for firms to determine the return of each project. A poorly chosen project could cause dysfunction or affect resources allocated to other projects. A study co-authored by a researcher at The Ohio State University Max M. Fisher College of Business says rethinking the project selection process could help minimize risk.
Moreover, the study finds that firms have to evaluate correlation and interaction effects, such as synergies among project returns, to make decisions. Interactions among projects are common in practice. When several projects are implemented together, the total return can be greater or smaller than the sum of those projects’ individual returns. For example, implementing two IT projects may create additional value through integration. However, two new product development projects that generate similar products in a small consumer market may compromise each other’s profitability.
Project selection committees should reconsider their practice of choosing one project at a time, according to the study Managing Underperformance Risk in Project Portfolio Selection. Instead, they should use what the researchers call the “project portfolio optimization” approach, whereby decisions for all projects are made at the same time. Nicholas G. Hall, at The Ohio State University, co-authored the study with Daniel Zhuoyu Long, at Chinese University of Hong Kong; Jin Qi, at the Hong Kong University of Science and Technology; and Melvyn Sim, at the National University of Singapore.
Comparing multiple projects simultaneously more accurately models issues such as risk and available resources, the study says. It also allows firms to see potential correlations between uncertain project returns and synergies between projects. By using the project portfolio optimization approach, firms can design less risky project portfolios that meet target returns, and balance upside potential and downside risk accurately.
To evaluate the risks of target returns, the researchers developed the Underperformance Riskiness Index (URI). Projects selected by minimizing the underperformance risk are more than competitive in achieving the target, the study says. Firms that focus on only the worst-case expected return ignore risk aversion.
Overall, the research helps firms consider project selection as a project portfolio optimization problem. Eliminating the practice of choosing one project at a time gives firms an opportunity to compare projects beyond just the payback period and risk characteristics. By calculating the correlation between uncertain project returns and considering the synergies between projects, firms can create less risky project portfolios that mitigate the uncertainty of returns.
