RISK AND UNCERTAINITY

Risk
The existence of several possible outcomes, which are known in advance
along with the related probability.

Uncertainty
The potential outcomes of a decision that are not known in advance.
Clearly, associated probability cannot be known either.

Methods of Dealing with Risk in Decision Making

1. Expected Value
The expected value represents the average outcome that would be
achieved if a decision were to be repeated many times.

Expected value = Weighted arithmetic means of possible

(EV) Outcomes
= ∑ (xi p(xi))

This formula represents the sum (Σ) of each possible outcome (Xi)
multiplied by its probability of occurring (p(x i)).

The decision rule would be to choose the outcome with the highest EV.
The sum of the probabilities of all outcomes must equal to 1.

Illustration 1
When an unbiased six-sided die is thrown, each side has an equal chance
(1/6) of being obtained. The expected value of throwing a die many times
is calculated as:
 Value Probability Product
xi p(xi) xi p(xi)
1 1/6 1/6
2 1/6 2/6
3 1/6 3/6
4 1/6 4/6
5 1/6 5/6
6 1/6 6/6
Total Σ (Xi p(Xi)) 21/6

21
The EV is therefore or 3½
6

What this means is that if the dice is thrown many times (many iterations
of the event), the average value of the throws would be 3½.

Since the expected value shows the long run average outcome of a
decision which is repeated time and time again, it is a useful decision rule
for a risk neutral decision maker.

Advantages of Expected Value

It reduces the information to one number for each choice.
The idea of an average is easily understood.

Disadvantages of Expected Value

The probabilities of the different possible outcomes may be difficult to
estimate.
The average may not correspond to any of the possible outcomes.
Unless the same decision has to be made many times, the average will
not be achieved; it is therefore unsuitable for decision making in “one-
off” situations.
The average gives no indication of the spread of possible results (i.e.,
it ignores risk).
2. Profit Table/Payoff Table
A profit table (pay-off table) can be a useful way to represent and
analyse a scenario where there is a range of possible outcomes and a
variety of possible responses. A pay-off table simply illustrates all
possible profits/losses.

Illustration 2
A baker sells a cake that costs $0.10 to make for $0.30 each. At the end of a
day any cakes not sold must be thrown away. On any particular day the
level of demand follows the following probability distribution:

Number of cakes sold 20 40 60

Probability 0.3 0.5 0.2

The following template may be used:

Order Size
Demand 20 40 60
20 (Pr 0.3)
(Outcomes are computed in this part of
40 (Pr 0.5)
the table)
60 (Pr 0.2)

Required:

a) Construct a profit table to show the possible outcomes?

b) Calculate the daily order the baker should place in order to
maximize the expected value of daily profits?
Value of Perfect Information
Imagine that, in a situation of uncertainty, it is possible to buy an accurate
forecast which predicts with certainty what the uncertain variable is going
to be each time a decision has to be made.
The value of perfect information is the maximum amount a decision-maker
would be willing to pay for advance information to know which outcome will
occur.

Value of Perfect Information = EV with Perfect Information - EV

Without Perfect Information

Illustration 3
The baker in Illustration 2 opts to buy a daily forecast which tells him in
advance of placing the day's order what demand for that day will be with
certainty.

Required: Calculate the value of this perfect information?

Value of Imperfect Information

Imperfect information is when the information is usually correct, but can be
incorrect.

Value of imperfect information = EV with imperfect information - EV

without information

3. Decision Trees
Decision making often involves multi-stage decisions. At each stage in
the decision-making process, the decision maker has to choose
between two or more decisions. The possible outcomes of each decision
will be specified, along with the associated probability.

Having made the first decision, a second decision or possibly even more
decisions may be required.

A "decision" tree helps visualize and evaluate outcomes in the

decision-making process.
Conventions and Process
Decision fork (point) − this is a point at which a decision- maker has to
decide between two or more decisions.

Action a

Action b

Action c

Chance fork (outcome point) − this occurs where there are several possible
outcomes. Normally, for each decision taken, there will be two or more
possible outcomes.

Outcome B
Probability P

Probability Q
Outcome A

The sum of the probabilities of all outcomes (branch) at each chance fork
must equal 1 or 100%.

Having drawn the decision tree, it is necessary to calculate the expected

outcome at each decision fork. To do this process, start at the right-hand
side of the decision tree and work back to each decision fork to identify
which is the best decision at each fork.
Ultimately, the decision tree enables the decision-maker to determine the
best decision to make at the first stage.
Illustration 4
A company is considering investing in a new machine. This would involve
an initial expenditure of $50,000 on patent rights, and profit in the coming
year could be:

$300,000 with probability 0.6

Or $200,000 with probability 0.4

If the company does not invest in the machine, next years' profits will be:

$250,000 with probability 0.7

Or $150,000 with probability 0.3

This can be illustrated as follows:

At chance fork B: Expected profits are $260,000 ((0.6 x 300,000) + (0.4 x

$200,000)).
At chance fork C: Expected profits are $220,000 ((0.7 x 250,000) + (0.3 x
$150,000)).

At decision point A:
Either invest: Expected outcome is $210,000 (260,000 - 50,000).
Or do not invest: Expected profit is $220,000.

Conclusion: The investment should not be made.

Types Of Decision Makers
Not all managers will make the same decision even though they have the
same information; as individuals, they have different attitudes toward risk.

1. Risk seekers are those who seek the maximum possible return
regardless of the probability of it occurring. As optimists, they consider
the best-case scenario.

2. Risk neutral is those who consider the most likely outcome.

3. Risk averse are those who dislike risk and so make decisions based
on the worst possible outcome.

4. Maximax, Maximin and Minimax Regret

Select the alternative with the maximum possible

MAXIMAX payoff (i.e. highest return under the best-case
scenario). The risk seeker's (i.e. optimist's) rule.
Select the alternative with the highest return under the
MAXIMIN worst-case scenario. The pessimist's rule (i.e. risk
averse).
Select the alternative with the lowest maximum regret.
Regret is defined as the opportunity loss from having
MINIMAX REGRET made the wrong decision. Minimax regret is also suited
to investors that are averse to missing out.

Select the option that gives the highest EV. Those who
use EVs may be described as risk neutral (i.e. they are
EXPECTED VALUE
not concerned with the amount of risk associated with
(EV)
each option only the amount of the expected return).
Illustration 5
From the payoff table given below:
State of the market Probability Project 1 Project 2 Project 3
Diminishing 0.4 100 0 180
Static 0.3 200 500 190
Expanding 0.3 1,000 600 200

Required: Determine which project would be chosen, using each of the

following decision rules:
a. Maximax;
b. Maximin;
c. Minimax regret.

5. Sensitivity Analysis
Sensitivity analysis takes each uncertain factor in turn, and calculates
the change that would be necessary in that factor before the original
decision is reversed. Typically, it involves posing 'what-if' questions. By
using this technique, it is possible to establish which estimates
(variables) are more critical than others in affecting a decision.

Sensitivity % = Profit ÷ Variable

Illustration 6
A manager is considering a make v buy decision based on the following
estimates:

If made un-house If buy in and re-badge

$ $
Variable production costs 10 2
External purchase costs - 6
Ultimate selling price 15 14
You are required to assess the sensitivity of the decision to the external
purchase price.

Solution
Step 1: What is the original decision?

Comparing contribution figures, the product should be bought in and

rebadged:

If made in-house If buy in and re-badge

$ $
Contribution 5 6

Step 2: Calculate the sensitivity (to the external purchase price).

For indifference, the contribution from outsourcing needs to fall to $5 per

unit. Thus, the external purchase price only needs to increase by $1 per unit
(or $1/$6 = 17%). If the external purchase price rose by more than 17% the
original decision would be reversed.

Advantages of Sensitivity Analysis

It gives an idea of how sensitive the decision taken is to changes in
any of the original estimates.
It can be readily adapted for use in spreadsheet packages.

Disadvantages of Sensitivity Analysis

Sensitivity is usually only used to examine what happens when one
variable changes and others remain constant.
Without appropriate software, it can be time consuming.

6. Simulation
Simulation is a technique which allows more than one variable to
change at the same time. Most real-life problems are complex as there
is more than one uncertain variable. Models can be generated which
"simulate" the real-world environment within which the decision must
be made.
Advantages:
It overcomes the limitations of sensitivity analysis by examining the
effects of all possible combinations of variables and their realizations.
It therefore provides more information about the possible outcomes
and their relative probabilities. This helps in highlighting implausible
assumptions and detecting bias.
It is useful for problems which cannot be solved analytically by other
means.

Disadvantages:
It is not a technique for making a decision, only for getting more
information about the possible outcomes.
It can be very time consuming without a computer.
It could prove exit relies on reliable estimates of the probability
distributions of the underlying variables.
Pensive in designing and running the simulation on a computer.

Focus Groups
Much of the uncertainty which companies face in the real world relates to
new products and whether they will be successful. To reduce this
uncertainty, focus groups may be used prior to the launch of a product.

A group of people are asked to give their opinion about a new product
or service. The discussion takes place in an interactive environment in
which participants are free to give their opinions and discuss them with
other members of the group.
Prior to the meeting, the members of the group may be screened to
ensure they belong to the target market to which the product is aimed.
Market Research
Market research is the systematic gathering of information about
customers, competitors and the market. The type of information gathered
in market research seeks to answer the following types of question:
Who are the customers?
Where are they located?
What quantity and quality do they want?
What is the best time to sell?
What is the long-term price?
Who are the competitors?

Market research can be used to help companies make decisions about the
development and marketing of new products. The earlier the market
research is conducted in the development of a product, the better, from a
risk point of view.