Uncertainty and Industry Structure Effects on Managerial Intuition About Information Technology Real Options

Abstract

Real options analysis is an important but costly tool for valuing many information technology (IT) investments. As a low-cost substitute for real options-based methods, firms often depend on managerial intuition, which sometimes approximates real options-based valuations and sometimes does not. Making good choices about how to value IT investments requires an understanding of why, and therefore when, intuitive judgment is more or less likely to be consistent with real options-based valuations. Field and survey studies have provided ex post observations of systematic variations in consistency by option type, but ex ante hypotheses explaining this variation have been rare. This study uses two behavioral economic theories to predict option-type-specific differences between intuitive judgments and real options prescriptions. Regret theory posits that individuals will value decision outcomes based on both the expected utility of payoffs and on anticipated regret for not having made an alternative decision. As a consequence, intuitive IT investment decisions are less aggressive as uncertainty increases (higher valuation of deferral options, lower valuation of growth options), in contrast to higher normative values for both real option types with higher uncertainty. Consistent with competitive behavior theories that predict overaggressive behavior to contest market behavior, intuitive IT investment decisions are more aggressive in the presence of a potential competitor (lower valuation of deferral and higher valuation of growth options), holding constant the normative value of the options. We present experimental evidence consistent with these predictions. An important implication of our results is that future research should not test for general consistency between intuitive judgment and real options theory, but should identify and explain systematic variation in consistency across option types and settings. Such variation is important in practice because it determines when intuitive judgment is and is not likely to be an adequate substitute for costly formal real options valuation. It also determines when training in real options concepts needs to be more intensive to overcome inconsistency with intuitive judgment, and when the outputs of formal real options valuation are likely to be unintuitive and thus not readily acceptable to managers with limited option theory training.