Published here January 2004. 

PART III | Reason 4 | What is Risk? | Project Risk Management
The Need for Project Selection Risk Management | Hurdle Rates
Characterizing Risks with Probabilities | Characterizing Project Risks
Organizational Risk Tolerance | PART V

Project Managers Benefit from Characterizing Project Risks

Although project managers may initially feel uncomfortable with probabilities, my experience is that this group can benefit significantly from moving away from using artificial point estimates. The following is a summary of an example devised by Mark Durrenberger of Oak Associates making this point.[3]

Imagine that a project manager is asked to complete a project in 3 weeks. Suppose the project manager feels that this estimate is unrealistically optimistic; that everything would have to go just right to make the deadline. The project manager may feel apprehensive about going to the project sponsor to address the problem. It may not be easy to explain why an optimistic, aggressive project schedule isn't a good one.

Suppose, instead, that the project manager estimates as a range the time required to complete each project step. Those ranges can be combined (by adding the means and variances) to determine the probability of completing the effort within any specified time. Rather than feeling "at the mercy" of the sponsor, the project manager can now say, "I understand your desire to complete the project within three weeks. However, my calculations suggest that we have less than a 5% chance of meeting that deadline."

The sponsor will want to know more, including how the probability estimate was obtained. This gives the project manager the opportunity to discuss the realities of the job and to negotiate tradeoffs. Such tradeoffs might include reducing project scope or deliverables so as to increase the likelihood of meeting the desired schedule.

Note that specifying ranges is not a license for the project manager to make baseless claims. Over time, performance can be compared with range estimates. A project manager whose performance routinely beats the means of his specified uncertainty ranges, for example, will be exposed as one who pads estimates!

Risks of the Project Portfolio

Another important reason to consider quantifying project risks is it that the overall risk of the project portfolio can then be determined. Conducting a portfolio of projects reduces risks through risk diversification (hedging) in the same way that an individual can reduce financial investment risks by investing in a portfolio of stocks. In a stock portfolio there is a limit to how much diversification can reduce risk. This limit is determined by the degree to which stock prices tend to move together; that is, the degree to which the prices of the stocks in the portfolio are statistically correlated with overall market movements. To understand the risks of a stock portfolio, it is necessary to measure these correlations (this is typically done using a correlation statistic called "beta").

In a project portfolio there are risks that impact multiple projects simultaneously. So, in exactly the same way as with stocks, a project portfolio is not as effective at reducing correlated risks. The only way to estimate accurately the risks of alternative project portfolios, and thereby choose projects that collectively produce maximum value at minimum risk, is to quantify these project risks, including distinguishing risks that impact single projects from those that impact multiple projects.

Fully characterizing project risks shows whether the assumptions required for using hurdle rates are satisfied and supports the selection of project-specific hurdle rates. It also allows the use of another approach involving the concept of risk tolerance.

Characterizing Risks with Probabilities  Characterizing Risks with Probabilities

3. M. R. Durrenberger, "True Estimates Reduce Project Risk," Oak Associates, Inc., 1999.
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