Dr. Richard Bayney on Portfolio Optimization
Despite evidence of the superior returns offered by Portfolio Optimization, this technique is still under-utilized by the R&D community. In this interview, Dr. Richard Bayney discusses some of the key reasons why executives should consider moving beyond sub-optimal portfolio prioritization techniques, and introduces CREOPM, a framework to help organizations maximize portfolio value.


What major trends have you observed in portfolio management?

Over the past few decades, not a lot of changes have occurred in the area of portfolio selection. By that I mean that the methodology by which companies actually select projects and programs for their portfolio has basically remained largely unchanged. They use either a single metric, either financial, or non-financial metric, or multiple metrics to actually select their projects.

The one area that I’ve been happy to see some change over the past decade or so is in fact in the area of resource management. Now companies have really woken up to the fact that while they used to focus rather myopically on budgets, that money is always fungible – you can move money from one area to the other – but that people by functional role are not. So now there is more of a dedicated focus, and it is high time that it has become that way, looking at resource availability in the context of resource capacities, to be able to actually support new projects above and beyond the budget.

What I anticipate happening over the course of the next decade or two in fact has a lot to do with what I see being focused on in the area of portfolio management and that is on cost containment.

Now, beyond the certain point, you cannot contain costs – at least this is my thesis – without compromising quality. So when you get to that so-called tipping point, you really have a challenge ahead of you, and so the question that you need to ask yourself logically is: “If I’m unwilling to compromise my quality (and you should) and I can’t contain my costs any further, how can I extract any greater financial value from my portfolio? Am I satisfied with my methodology of choice to select my projects and programs? And if I’m not, is there in fact a superior methodology to be able to extract greater value?”

That I expect to see in the next decade or so.

Why isn’t portfolio optimization more widely practiced within R&D?

That is a question that really requires successful organizations to take a step back despite their own success. Now, let’s assume that you are the CEO of a company and have in fact enjoyed protracted success. Now if you’ve met your numbers, you’ve met your goals every year, what incentive do you really have for asking yourself the following question, “Despite my protracted success, how much more successful could I have been?”

There are very few senior decision-makers that I’ve met in my time who would really ask themselves that question. Now, if you’re a CEO of a struggling company, you certainly have a much larger “raison d’etre” as it were for asking the question, “Could I have done any better?”

There are indeed superior methodologies for portfolio selection that have existed for decades. Now in 1952, Markowitz and others described the economic efficient frontier . That is a superb technique that has been employed in many industry sectors including the financial industry, manufacturing, distribution logistics, to actually extract the greatest value possible without violating any constraints and respecting your strategic considerations.

This is certainly not a novel idea. This idea has been around for decades, it has just not been utilized particularly well within the R&D community because by and large, most of our senior decision-makers have not really been educated in the areas of operations research, which is a discipline within which portfolio optimization falls. They are incredibly comfortable with project prioritization or ranking of projects to enable their portfolio selection.

What are signs that a company is ready for portfolio management?

In fact, over the many years that I’ve either been a part of an organization or consulting for others, I have seen a couple of signs on the wall.

First a general dissatisfaction with the level of transparency around decision-making that tends in fact to be dominated by politics, heuristics, advocacy, and the persons or individuals with the largest voice. Generally, when I see that there is the sense that there is some level of dissatisfaction amongst the ranks that decision-making that lacks transparency is probably not going to be the most value adding and logically consistent.

There are other reasons including organizations who say to me: “Well, we’re not mature enough so we’re not ready for this.” Mind you, these are organizations that have been in existence for decades. If you’re not mature enough yet, then I really don’t know how much longer it would take for you to be mature enough to adopt these cutting edge practices.

One of the most popular ones I run into is an organization that says to me: “Yes, this is interesting, but over the next 6-12 or 18 months, we expect either managerial changes or another re-organization so we need to wait until that dust actually settles before we embrace something as cutting edge as, for example, portfolio optimization or working with the economic efficient frontier.” Before you know it, there’s another restructuring, another series of moving the decks on the sinking Titanic, and nothing really ever gets done.

So generally, a plethora of reasons for avoiding looking in the mirror. Remember, the emperor really doesn’t like to be told that he’s wearing no clothes. So that’s not an easy statement for people to hear when they’re trying to do the best they can, but really need to take a look at the dogma they are pursuing.

How do strategic, portfolio, and business plans relate to one another?

The strategic plan is an overarching plan that ought to dictate to an organization what you plan to look like when you grow up. But that needs to have quantifiable goals. In other words: “How do I know that I’ve arrived at a given destination?”

Now, consider that to be at the apex of a pyramid. Supporting that is the next layer of the pyramid which is the portfolio plan. The portfolio plan should actually be constructed in a manner that is completely supportive of the strategic plan.

Then and only then, at the lowest tier of the pyramid, should we have the business plan which is basically a financial and a resource plan that essentially supports the portfolio plan.

Now I hasten to add that there ought to be bi-directional interdependence between these three plans. Here’s what I mean by that. If something changes at the highest level of the pyramid, i.e. the strategic plan, the portfolio plan should inform the strategic plan regarding the likelihood of meeting its quantifiable financial and other goals, and in turn, the portfolio plan should inform the business plan about what is necessary to enable the portfolio plan to become actionable. Without that level of inter-dependence, we can have 3 lovely plans in a PowerPoint slide that are not intimately connected.

Tell us more about CREOPM, the portfolio management framework.

CREOPM is not just a tool, it is both process and methodology. Now it is a 6 dimensional process that allows you to actually maximize the value of your portfolio however you define the term “value.” Now, I would prefer to talk about financial value – not everyone does – but at the end of the day, most of us are actually trying to maximize financial value and why not?

  • The “C” stands for Categorization of the opportunities within your portfolio. Now these opportunities can be both discretionary – meaning you may and may not do them – and non-discretionary – meaning you have an obligation, perhaps a regulatory obligation, some type of compliance initiative to fulfill. That’s the “C.”
  • The “R” refers to Risk analysis, in a phase-dependent manner. Most R&D projects go through a series of phases or gates and that’s what the “R” stands for.
  • The “E” stands for an integrated Evaluation that actually combines the following four metrics: benefit, risk, cost, and time, to give you a risk-adjusted value – most often than not, a risk-adjusted net present value (NPV).
  • The “O” stands for portfolio Optimization which is trying to actually find the combination of projects and programs, not the rank order, the combination of projects and programs that maximizes value subject to a resource constraint or in fact a particular risk-tolerance.
  • Now the “P” stands for Prioritization or rank ordering of projects.
  • Then the “M” stands for Management. Basically the management of resources, management of risk, management of stakeholders, and management of your own capability maturity level.

That is CREOPM.

What are the objectives of CREOPM?

Now what CREOPM does is actually two-fold. It does maximize portfolio value but secondly it helps organizations to build their portfolio management capability maturity levels. Now let’s make sure we understand what I mean by building those levels.

It is easy to take data and throw it in a sophisticated software system and generate great graphics or great analytics. But how do we know that the data is actually robust, that the pedigree is there to support good analysis that hopefully actually facilitates good decision making.

CREOPM is both process and methodology. Let’s call process essentially vetting and validating data to make sure that it is robust, transparent, and logically consistent. Then the optimization allows you to maximize value, subject to the constraints that you have. That is why the combination does more than just maximize portfolio value. It also builds your organizational competencies.

How do the ROI of the portfolio optimization and prioritization compare?

There are only two types of feasible portfolios that exist. There is the optimal or efficient portfolio, then there are a multitude of sub-optimal or inefficient portfolios.

Now if you can imagine an efficient frontier as a concave line, being on that curve represents the best that you can do for any level of resource or any given level of risk. No feasible or actionable portfolios lie north of the efficient frontier. That’s the line to which I refer. But a plethora of portfolios that are both inefficient and sub-optimal lie to the south of that line or efficient frontier.

So if you were to move along the x-axis and let’s call the x-axis “resource,” for any given defined point on that x-axis, there is one and only one combination of projects and programs that lies on the efficient frontier that is indeed the optimal portfolio for any given level of resource or risk. South of that, lie a plethora of portfolios that are all sub-optimal.

So by definition, the ROI of an optimal portfolio will generally exceed the ROI of a sub-optimal portfolio unless that portfolio that has been selected by, for example, a prioritization or a rank ordering methodology purely happens to serendipitously fall on the efficient frontier. That’s the only way that the two ROIs are going to be the same.

What would prohibit an organization from using portfolio optimization?

Portfolio optimization ought to be the logical choice for most if not every organization that’s trying to maximize value. The problem is that human beings generally get in the way of its use and let me tell you what I mean by that.

Clearly, no one should ask a mathematical program or piece of software to make a decision for them. They instead ought to use good analysis, being generated by good models, including software to essentially be used as an aid to good decision-making.

The problem I’ve encountered is that over the years, no one really asks for “what is the best that we can do?” because if we engage in our own politics and advocacy and heuristics, then we can pick and choose the things that we do just because we are profitable and it seems to make sense.

That is what I call “being good enough.” The question is though, is “being good enough,” really good enough to continue to sustain your business?

The way to defend projects that really shouldn’t be in the portfolio – and by the way these are called “pet projects,” and every organization basically has them – is to select them on a “one or other” basis. Now the number of times I’ve seen projects that have very weak financial value that actually squeezed themselves into a portfolio only because they have this thing that is called “strategic value” as a justification for getting them in is a far more than I care to remember.

Now if you ran that through a mathematical program, your pet projects, if they don’t bring a lot of financial value would rarely ever make it into the optimal portfolio. The way to actually obviate that is to say let’s not run a mathematical program, let’s not look for the efficient frontier. We are seasoned decision makers and we can make good judgments. So let’s just use our good experience, our good judgments and make our portfolio selection.

Remember, once you’re successful, you can continue to do this, but if you never ran a parallel experiment or analysis to basically ask the question how much better you could have done, you will never know how much value you’re leaving on the proverbial table.

Does using Portfolio Optimization relate to organization’s maturity level?

There isn’t necessarily a relationship, and so I’ll give you two good examples of this. The first example is at Bristol-Myers Squibb in my own experience. Now in 2001, in fact, having endured a three-day-long portfolio review, that organization was taken by myself and my department – I did not do this single-handedly – to a four-hour portfolio review. The first question the executive committee asked me was: “Show us the optimal portfolio.” Meaning: “Tell us what is the best that we can do. And now, help us decide.” They did not say, give us the answer from the mathematical program.

Now that would be an example of a company that was well along in the maturity curve.

There’s another company – this is a current client so I can’t give you the name – they’re in the US and last year, they asked me: “We really don’t have a formal portfolio management system. Can you get us started and let’s see how far we can go with this?”

Now the agreement was that when the portfolio review was completed, I would do this by project ranking or project prioritization. They would use that as the basis for decision-making. Remember, this is a company that had no formal portfolio management system in place. But they said: “Why don’t you just run a pilot study to see if this portfolio optimization technique that you keep talking about works at all?”

Yes, I ran the pilot. The delta – that is the difference in value between the portfolio selection methodology that they had originally chosen, and the pilot methodology based on a part of CREOPM that I recommended – was so large that they said: “Forget about this project prioritization technique, let’s use portfolio optimization because it is clearly a superior methodology.”

So I’ve given you two cases where one it was an organization that was relatively mature and the other, starting out in formal portfolio management for the very first time that decided that in fact it was quite ready to embrace this technique.

So it is less a question of how mature the organization is, but in my mind it is much more a question of what type of senior stakeholder engagement you actually have to be able to drive the process and the methodology forward.