Working with senior stakeholders to optimise the value of a portfolio of projects is a complex process influenced by the innate bias in most people including risk and loss aversion and the preference for ‘quick wins’ over long-term gain. The challenge is to convey quite complex modelling ideas in a way that is easy to relate to.
Unfortunately, the relatively straightforward process advocated in the PMI Standard for Portfolio Management 3rd Edition of ‘ranking’ projects and then selecting the highest ranked projects for implementation is guaranteed to produce suboptimal long-term outcomes.
The process of modelling portfolios has been progressively enhanced since the introduction of the concept by Harry Markowitz in the 1950s. The concepts are used across a diverse range of portfolios including share portfolios, retirement planning, oil and gas exploration and financial derivatives. A portfolio of projects is no different and should use these modelling concepts to optimise value, but applying the techniques requires skill and care which is beyond the scope of this post, so the first part of the challenge is to get expert help.
[Note: The GFC of 2007/08 was caused by fundamentally flawed models that ignored the possibility of house prices falling and also ignored the convergent risks inherent in the subprime mortgage market. If the practices discussed in this blog were used, both the ‘bubble’ and the bust would have been avoided by far more financial institutions, as demonstrated by both Canadian and Australian banks that were required by law to use more conservative investment policies.]
Most people would agree that the best outcome from any investment portfolio is obtained by balancing risks and rewards within an appropriate risk profile. If you set the organisation risk appetite too low, the returns on the monies invested will be dismal: you would be better off leaving the money in the bank or government bonds. But if you accept too much risk there may be unacceptable levels of failure. Deciding on an appropriate level of risk to maximise the sustainable value of the investments and the organisation as a whole is a key governance decision which requires the relatively sophisticated modelling identified above.
What is rather strange is many organisations will spend tens of millions of dollars a year on their projects and programs without proper analysis of the overall portfolio, but almost all of the directors and executives in those organisations have superannuation portfolios and expect their financial advisers to maximise the returns using the same portfolio modelling techniques to optimise the diversification and risk spread based on the objectives of the individual.
The key driver affecting decisions in a superannuation portfolio is the objective of generating a ‘safe’ return in a volatile share market but where bond yields are typically low. The key parameter is the expected time to retirement:
- Ten or more years: a portfolio of mainly equities generates the best return
- Five years: a balanced portfolio is safest
- One year to retirement: the optimum investment shifts to bonds.
A few of the key parameters associated with the effective modelling of a portfolio of projects and programs include:
- Recognising projects DO NOT have a set cost: there is a range of potential cost outcomes for every project and program.
- Similarly, the cost of the associated change program needed to incorporate the project’s outputs into the organisation’s operations is variable.
- Recognising projects DO NOT have a set of guaranteed benefits: the benefits actually realised are variable and will be influenced by many factors including:
—the time needed to deliver the project’s outputs;
—the effectiveness of the change program within the organisation;
—the effectiveness of the organisation’s management in using the outputs to create beneficial outcomes that generate value;
—changes in the environment the organisation is operating within that can make the outcomes more or less valuable;
—the perceptions and speed of adoption of the new product or service by customers, clients, and others outside of the organisation;
—the length of time the new ‘product or service’ remains viable in the marketplace.
Achieving the strategy
Consequently, organisations are more difficult to model, but the modelling process is more important. The key driver for a portfolio of projects and programs should be a carefully thought out strategic plan with success measured by the achievement of the strategy. Developing the strategy should be a joint process with input from both the ‘Board’ and management; approving the organisation’s strategic plan is a critical governance responsibility.
Once the governance framework consisting of a defined risk appetite, an appropriate budget and a practical strategic plan has been established by the Board, the role of portfolio management is to implement these policies and to provide assurance and advice to the Board that the management decisions are optimised within the governance framework—this requires modelling!
In exactly the same way superannuation portfolios diversify and seek income from an appropriate mix of fixed investment (cash, bonds, etc), share price movements and dividends based on needs of the individual, the ‘project portfolio’ should seek value from a mix of projects that balance:
- ‘Keeping the lights on’: short-term mandated or essential work required to keep the organisation operating.
- ‘Business improvement’: medium term projects designed to reduce costs, improve efficiency and/or expand capacity within current areas of operation.
- ‘Business enhancement’: longer term projects designed to enhance, expand or improve the current business by closing non-performing areas, expanding into new areas and delivering upgrades or other improvements in the products and services offered by the organisation.
- ‘Business creation’: the high risk, high reward projects that will develop the organisation of tomorrow focused on innovation, R&D and experimentation.
Your executive may not appreciate the sophistication of portfolio modelling any more than I do—after all, it is the domain of experts—but almost everyone has a superannuation fund and the analogy outlined in this post will go a long way towards starting the right sort of conversation focused on optimising the delivery of strategy.
An accessible read on portfolio modelling can be found in the second half of The Flaw of Averages by Sam L Savage.