Product Development Payoff Asymmetry

I recently gave a talk at a conference about “Tilting the playing field in product development”. I went through a number of “False Friends” – things that seem like a good idea, but actually lead us into trouble. The last of these was “Certainty”. The story here revolved primarily around the stochastic nature of product development – and what we can do about that. For starters, don’t fool yourself into thinking the benefits are certain, no matter what your gut is telling you. (If they are, your competitors are probably already there and you’re just playing catch up). Succeeding in product development requires the discovery and exploitation of options where there is an asymmetry to the payoff function.

What does this “asymmetric payoff” mean though? Well, to illustrate, let’s look at an example – the financial call option:

Financial long (call) option

The holder of a call option has the right (but not the obligation) to buy something at a certain time at an agreed price (called the ‘strike’ or exercise price). If the value of the “something” turns out to be less than the exercise price, clearly they would elect not to buy. In this case the option is “out of the money”. Because of this, the maximum downside risk to the option holder is the price that they paid for the option in the first place, which is called the premium.

Conversely, if the value of the “something” is above the exercise price they would take the option and buy the “something” at the price previously agreed. At first they are simply paying back the premium. Beyond the exercise price + premium, it is pure profit. What makes this interesting is that the potential upside is unlimited. Limited downside, Unlimited upside = Asymmetric.

Of course, it depends what the likelihood of these different outcomes are. For that we can overlay the probability distribution we believe the different outcomes have. In this case we’re assuming it’s a fat-tailed distribution:

Fat-tailed Probability Distribution

Now, if we put these two together we can visualise the upside and downside risk – and see the asymmetry of the Call Option. (Out to the right, you can see where the positive Black Swans are for financial Call Options):

Call Option Asymmetric Payoff

Unfortunately, things are not so clear cut or clean in Product Development, the downside risk is much higher and the probability of getting any sort of return on investment is relatively small. There are lots of risks, different paths to take, many degrees of freedom and lots of ways it can go wrong. But if I was generous I could imagine the payoff curve in product development to look something like this:

Typical Product Development Payoff

If anything, with the typical approach, the asymmetry is to the downside. Every now and then though, we might get lucky and even (way out to the right) land upon a Black Swan – those rare, extreme events that are only obvious in hindsight. The important thing to recognise though, is that there are things we can actually do in the way we approach this space that can improve the asymmetry in our favour. We can tilt the playing field, manipulating the payoff curve and probabilities like this:

Asymmetric payoff – Tilted playing field – Black Swan Farming

The worst examples I’ve seen of wasting money in organisations have been rooted in certainty. One of the sources of certainty comes from Senior Executives “trusting their gut” when making key decisions. Consequently they choose to test the water with both feet, on big, bold ideas – that all to often turn out to be largely worthless. Project mentality doesn’t help either. If you look at the CVs of a dozen Project Managers, a bunch of them will boast about the size of their projects they have managed. We seem to be addicted to big projects.

It doesn’t have to be like this though. For more on how to tilt the playing field in your organisation, take a look here. For more on Real Options, (and how this relates to organisational agility), take a look here. For anything else, drop us a line here!