Understanding Real Options

I had the distinct pleasure of spending time with Chris Matts and Olav Maassen last week at the Seattle APLN Leadership Summit. It was a good time all around.

We explored the impolite topics of religion and politics and even shared an idea or two about Agile Leadership. Talking with Chris and Olav was the first time I had anyone sit down and explain to me the concept of Real Options. I was fortunate that I got to hear it straight from the guys that are driving some of the thought leadership in this area.

There is no better way to solidify a concept in your brain than to write about it and teach it others. I am no expert on Real Options but would like to see if I can share with you what I learned. Hopefully we'll generate some conversation along the way.

The concept of Real Options is very straightforward. It is so straightforward that you can summarize it on the back of a business card:

Options have value
Options expire
Never commit early unless you know why

Like most things that appear simple, I think there is a little more to the story, a little more that needs to be explained.

Options Have Value

An option is a choice. It is a decision to select one strategy over another strategy. To buy one product over another product. To build one feature over another feature. To decide on one course of action over another course of action.

Every choice we make has the possibility to yield a particular return on our investment. Our goal is to maximize the value that we derive from our decision making.

Our options, the decisions we make, have value. The interesting thing here is that it is not just the options we know about that have value, the options we don't know about have value too. We are generally pretty good at determining the value of the known options, but what about the value of the unknown options? That's just it… we can't know the value of an option that isn't there yet.

We need time to learn about what we don't know.   We need time to understand the value of the unknown.

Options Expire 

Options have value, but that value does not live forever, it expires. We cannot wait indefinitely to make a decision and we can't wait until we know everything. At some point in time, the window of opportunity for a particular option will close, and the value of that choice will no longer be available to us.

Our goal is to keep our options open until just the point they are ready to expire. We use that time to gather more information and to learn about new options that might present themselves.

Waiting to the last responsible moment, just before the option is ready to expire, allows us to make decisions when we have the most possible information available to us. Decisions cannot be held indefinitely... but they can be deferred.

Never commit early unless you know why

Most people want to make good decisions. Unfortunately, most people would rather make a wrong decision than to live with uncertainty.

This was probably the most clarifying concept I learned during my time with Chris and Olav. We would rather be wrong than to defer a decision. Our need for certainty drives us to make decisions before we have to. Sometimes it drives us to make bad decisions.

Waiting helps us make better decisions. Knowing how long we can wait helps us be more disciplined about waiting. Using Real Options theory can help us determine how long we can wait.

If you need to make an early decision, the key is to understand why. Don't make a decision early for the sole purpose of making the decision. Wait and gather more information. If there is a good reason to make the decision early, and you are comfortable with the outcome, make the decision.

Sometimes there are good reasons for making an early decision. If the value of the option is low or of little risk, you might consider making an early decision. In that case you are making the decision to focus your energy on higher value options. Alternatively, if a situation is high risk and making an early decision would yield an acceptable outcome, that might be a good time to make a decision early. Making the decision would mitigate risk.

Understand why you are making the decision and be aware the limits that decision will place on any current or future options.

So… that is my take on Real Options. If any of you are experts on this topic, please weigh in. I found the concept intriguing and wanted to share with you my understanding.

Comments

[Shri]

I confess, I am one of the ones that can't stand uncertainty. I like to make decisions and make it now. This article was very eye-opening. The value of trying to defer the decisions to the last responsible moment so that I can explore the unknown options really stood out for me. I commit to remembering this and trying it out in my life as well as my job. In a future journal, I will comment on what I learnt while trying this new thought-process.
Thanks for helping me out through this blog !

[Mike Cottmeyer]

Thanks for your comment Shri. I look forward to hearing about how managing your options ends up working out for you.

For the record, I am generally pretty bad at holding my options too. Making decisions comes naturally to me and I have a decent track record. I wonder how much value I have missed out on by making decisions too early?

Mike

[Ken Ritchie]

I'd like to add a corollary to the back of that business card:

*Values may change*

Sure, that could be implicit in the expiry of an option and it's former value. I might infer such a thing, and replace an option with a revalued one. However, such a strategy seems too complex... I'd rather keep it simple and obvious, and acknowledge that the value of unexpired options may change.

What do you think, given the recent conversations you've been engaged in?

[Ken Ritchie]

Is there hope for early deciders?

There was a fascinating article, ten years ago, about delayed commitment as a design strategy: Harold Thimbleby's "Delaying Commitment," IEEE Software, v.5, n.3, p.78-86, 1988. Another of my all-time favorites is Parnas' classic article, "On the criteria to be used in decomposing systems into modules," Communications of the ACM, v.15 n.12, p.1053-1058, Dec. 1972. Parnas brilliantly (remember, this was in 1972) "postponed" and separated difficult subproblems by encapsulating their information and behavior together into modules (think of objects), which also yielded benefits later on by limiting the scope and impact of changes to one, or a few, components of the software.

These articles gave me the insights I needed, early on, into *why* certain design strategies worked better--at least in software, which is where I have made my career.

Since then, folks in the Lean software community have also promoted option generation by "set-based design" strategies, and by delaying commitment to the "last responsible moment." For example, see Mary Poppendieck's nifty article in SD mag, (August 01, 2003, exactly five years ago tomorrow!) http://www.ddj.com/architect/184415014 -- and see the inset box, "Amateurs Strive; Experts Hide" (Professor Thimbleby's rules for delaying commitment and their modern-day counterparts). NOTE: SD mag merged into DDJ.

David J. Anderson has also blogged about "real options" and such things, at http://www.agilemanagement.net/ - I often look up David's columns to observe how he synthesizes a lot of relevant material (from FDD and TOC to Lean and Kanban and more).

So, back to my "hope" theme...

Cognitively speaking, I believe that a high "ambiguity tolerance" helps ;-) In my learnings with Jerry Weinberg and friends, it has been a commonly-held opinion that those people with the "NF" dimension in their Myers-Briggs Type Index (MBTI) or Kiersey Temperament Sorter (KTS) tend, intuitively, toward "keeping their options open." I have no data on whether a high tolerance for ambiguity can become a learned behavior for those in whom it isn't already a natural inclination. However, I do believe that the relevant decision postponement and option generating strategies can certainly be learned, embraced and applied by anyone.

So, yes, Mike, there is hope...even for early deciders. Just make room for some option clutter.
;-)

[Ken Ritchie]

One more for the card?

*Failure to commit is also an option*

;-)