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The goal for selecting projects is to pick project portfolios that create the greatest possible risk-adjusted value without exceeding the applicable constraint on available resources. Economists call the set of investments that create the greatest possible value at the least possible cost the "efficient frontier." Most organizations fail to find the best project portfolios and, therefore, do not create maximum value. Inability to find the efficient frontier is the fifth reason organizations choose the wrong projects. If the problems discussed in the previous sections of this paper are addressed, value-maximizing project portfolios can be found. Specifically, if the organization has the right metrics and models in place, including the ability to value risk, and it has taken steps to minimize errors and biases in inputs provided to those models, the capability exists to estimate the value that would be added by doing any proposed project portfolio. It is a relatively easy last step, then, to find the best combination of projects. The concept of the efficient frontier is highly useful in this regard. |
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The Efficient FrontierSuppose that an organization is currently conducting a set of projects represented by the point labeled Portfolio A in Figure 37. Economists would describe Portfolio A as inefficient because there is another project portfolio, Portfolio B, that produces more value for the same cost. Similarly, there is also a Portfolio C that produces the same value for less cost. Furthermore, there is a Portfolio D with a combination of these two characteristics.  Figure 37: Different project portfolios have different costs and values. Now suppose we consider all of the alternative project portfolios that can be constructed from a set of project proposals. Typically there are many, and Figure 38 illustrates a real example. In this case the organization had 30 project proposals under consideration in one budget cycle. Four of those projects were considered mandatory (3 process fixes and a new initiative required by regulators), leaving 26 discretionary projects.  Figure 38: The best project portfolios define the efficient frontier. In general, if there are N potential projects, there are 2N possible project portfolios. (This is because there are a total of 2N subsets within a set of N items; see Mathematics: Methods for Solving the Capital Allocation Problem for more explanation). Thus, this application required evaluating 226 or approximately 67 million portfolios, far more than shown in the Figure 37! The best portfolios define the efficient frontier. Portfolios along the curve are said to be "efficient" because they allow the organization to obtain the greatest possible value from any specified available budget. Finding the Efficient FrontierIt is relatively easy for a computer (with an efficient optimization engine) to try various combinations and locate the efficient frontier, provided the right algorithms are in place for determining how the costs and benefits of individual projects combine to determine the costs and benefits of the project portfolio as a whole. In simple situations where projects are independent and risks are independent or do not matter, the costs and value of the project portfolio are basically just sums, respectively,
of the costs and value of the individual projects. In this case, the
value-maximizing portfolios can be obtained by ranking projects based on the ratio of project benefit to project cost. Thus, the portfolios on the efficient frontier are obtained by adding projects
in the order of benefit-to-cost ratios. Figure 39 illustrates.  Figure 39: With independent projects, projects are added to portfolios based on B/C. The Characteristic Curve of the Efficient FrontierNotice how the efficient frontier is curved, not straight. This is because the efficient frontier is constructed such that the best projects are included in the least-cost portfolios, i.e., those portfolios that show up first on the left side of the curve. Such portfolios create the greatest "bang-for-the-buck," and, therefore, the slope of the curve is steepest here. As the cost constraint is relaxed and more projects can be added, the new projects are not quite as good as those included earlier. The slope of the curve encompassing these projects is flatter because their bang-for-the-buck is not quite as high. Thus, there is a declining return in the value obtained with each additional increment of cost. This is what causes the curve to bend as shown in Figures 38 and 39. The 80/20 RuleVilfredo Pareto, the Italian economist, was the first to report what has become recognized as a common rule describing how dissimilar objects are often distributed. Specifically, Pareto observed that approximately 20% of the people owned 80% of the wealth. Since then, this relationship has been observed in many business contexts, for example, that 80% of profits come from 20% of customers, that 80% of results come from 20% of the effort, and that 80% of the value can be achieved from just 20% of the activities. The relationship is not exact, of course, but it is close in a surprising number of situations. It has become to be known as the "law of the trivial many and the critical few," or, more simply, as the 80/20 rule. The curvature of the efficient frontier is such that it often corresponds closely to the 80/20 rule. Roughly 80% of the value available from doing all projects may be achieved by doing just 20% of those projects (assuming, of course, that the best projects are chosen). The lesson is similar to other instances where the rule applies—Managers should concentrate on identifying and doing the few things that are critical rather than wasting effort on the many things whose impacts are trivial. |
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Risk Tolerance & Part 4 References