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When given a choice between getting $1,000 with certainty, or having a 50% chance of getting $2,500, most people will choose the certain $1,000 — even though the expected value (the average value over repeated trials) of the uncertain option is $1,250. Most people would reject a gamble where they would gain $100 if a fair coin lands on heads, and lose $100 when the coin lands on tails, because losses have a much higher impact than gains.
This idea of prospect theory, developed by Tversky and Kahneman and reported in a classic 1979 article (for which the Nobel prize was awarded) demonstrated that individuals do not make decisions rationally by selecting options with the highest expected value, because they are risk-averse and 'losses loom larger than gains.'
There's evidence that firms are no different. They overinvest in incremental innovation, and underinvest in innovations that would create "must haves" that would define new subcategories, which, with rare exceptions, are the only innovations that create real growth. I won't review this evidence here (If you're interested, see Brand Relevance) but will instead explore the question: Why do we see this suboptimal, timid investment pattern? There are four interrelated reasons:
1. Firms and key decision makers are simply risk-averse. Instead of trying for home runs, they're content to invest in low-variance singles represented by incremental innovations in existing offerings within established categories. "Better, cheaper, or faster" is the mantra for improving brand performance. Firms and their executives, like the subjects in the Tverskey and Kahneman experiments, have an aversion to losses, and a tendency to undervalue gains. An innovation that will provide a predictable increase in the sales and profitability of an existing business will be more attractive than an alternative that will offer a chance at a large profit platform, but with a significant probability of the loss of money and resources that could have been spent elsewhere. What's more, an innovation that disappoints in development — or worse, in the marketplace — can be a career path setback.
2. It's difficult to make assumptions about the unfamiliar. Estimation of the prospects for substantial or transformational innovation will depend on some uncertain market factors. And, the estimate usually needs to be based on insight, not data. In particular, customer feedback for something extremely new — a departure from the familiar — is known to be difficult to obtain, and even erroneous. Innovators from Henry Ford ("They would ask for a faster horse") to Steve Jobs ("We do not do market research") have made the point that consumers are not helpful when the context is unfamiliar. In addition, success will often depend on technological and other advancements, the route to which may not be apparent.
These uncertainties — coupled with the fact that a major innovation will have a long tail, and the fact that being attached to an optimistic forecast that fails to materialize is a risky career move — can cause a firm to underestimate the innovation upside and its probability of occurring.
3. It's difficult to get a budget for new ideas. The large, established business units within a firm usually control or have a heavy influence over budgets and strategies. Their business executives will already have a list of incremental innovations that they believe will further their business. They're unlikely to tee up major innovations that don't fall into their space. At Microsoft, for example, the Office and Windows operations have tended to suffocate innovations over the past few decades.
4. It's easy to kill an innovation project. The limitations of the resulting offering, coupled with pessimism about technological advances, provide justifiable "no-go" decisions. In 1998, GM killed the EV1, a battery-operated car, just before a breakthrough in battery technology occurred, in what GM CEO Rick Wagner opined in 2005 was GM's biggest strategic blunder. Market size estimates based on existing flawed products can be biased downward. For example, e-readers were around for a decade, but didn't get traction until Kindle created a better user experience and made e-readers more accessible. Finally, the right application or market may not yet be identified or targeted. For example, Joint Juice — a product to deliver glucosamine in liquid form for reducing joint pain — initially targeted young- to middle-aged athletes when the ultimate big market was an older demographic of people who wanted lower-calorie, less-expensive products.
Firms with growth and energy — like Apple and Nike — have found ways to make substantial and transformational market innovations. Most firms, however, fail to find and support big idea innovations. The result is a failure to generate new growth platforms, and a constant struggle to engage in "my brand is better than your brand" incremental innovation.
Every firm needs a balanced portfolio. You can't just support homeruns. However, some game changers need to be included, which means that biases against game changers need to be neutralized. Meaningful innovation needs to be supported, even when the odds appear to be stacked against you.