Decision-making under risk Flashcards
When does risk occur?
*When there are a number of different potential outcomes from the decision that can be forecasted.
How are decision made when risk are taken into account?
*The outcomes can be quantified using past data.
*This allows the use of mathematical techniques to assist decision making.
What are the risk attitudes/appetites when making decisions?
*Risk neutral: Is the realist the value upside and downside equally. Would accept a bet that would win or lose them $1 on the 50/50 toss of a coin.
*Risk averse: Is the pessimist they value downside disproportionally. Would reject a bet that would win or lose them $1 on the 50/50 toss of a coin.
*Risk seeking: Is the optimist they value upside disproportionately. Would accept a bet that could win them $1 or lose them $2 on the 50/50 toss of a coin.
What techniques can be used for risk decision making?
*Expected Values (EV)
*Payoff tables with probabilities
*Decision trees with probabilities
*Standard deviations
*Co-efficient of variation
*Sensitivity analysis
*What-if analysis
EV Explained
*Requires quantitative assessments of probabilities (P) and pay-offs (x) for each potential outcome.
*Provides an expected value which is the average of the probability weighted outcomes.
*Used for sales, cost, and profit outcomes for a decision.
What are the advantages of expected value?
- Takes risk into account in a formal way.
*Provides a single figure which is useful for decision making purposes.
What are the limitations of expected value?
*Does not always reflects the real outcome.
*Sensitive to outliers: Expected values can be heavily influenced by outliers or extreme values in data.
*Not appropriate for one off decisions because it takes an average outlook on the long term.
What are pay-off tables?
Where you tabulate the outcomes and the probabilities there off using expected values.
What are decision trees?
It is another way to visualise and calculate expected values.
How do you read a decision tree?
Decision trees are read from the right to left
What are the advantages of decision trees?
*Very good technique in general, even without numbers it shows the issues in a decision.
*Permits evaluation of more complex and multi-step problems (for example before deciding on market testing it is necessary to know whether the eventual product will be profitable)
*Highlights crucial factors in a decision
Disadvantage of decision trees?
Uses EVs so very sensitive to assumptions about probabilities of outcomes.
What is standard deviation?
Gives us better clarity, measure of the dispersion or spread of a set of values in a dataset.
