Post on 05-Jan-2016
description
Decision Making Under Uncertainty
Think Clearly – Act Decisively – Feel Confident
What’s in a decision?
Sven Roden
Unilever
How to get senior managers interested in decision analysis…
This is a demonstration to illustrate all the key fundamentals of decision-making when faced with uncertainty, while still keeping it so simple as to be “obvious”.
Making it thought-provoking and experiential creates a high impact event.
This example has been adapted from an exercise developed and demonstrated by the Strategic Decision Group (www.sdg.com)
We will demonstrate the principles of Decision Making Under Uncertainty using a
simple (but real) example
• This is a personal investment decision.
• The outcome is uncertain.
• The potential gains/losses are real.
What is the most that you are willing to invest?
Let’s create the most simple decision we can…
Invest
Don’t Invest
Decision
– £ X
Decision
Good
Bad
Uncertainty
Uncertainty
Outcome
Coin
0
0
– £ X
Net Profit
Coin - £ X
0
What is the value of the coin?
Ultimately, you have to work out what the coin is worth to you…… but here is some information that may help you!
£240 to buy a 1982 minted ½ Krugerrand (based on £400 per ounce)Source: http://www.taxfreegold.co.uk/krugerhalfdates.html
Krugerrands are legal tender in South Africa. The coin has a face value of ~ £ 0.03. Source: http://www.reuters.com/finance/currencies
Spot price for 1 troy ounce of gold is US$ 945 Source:http://www.ft.com/markets/commodities
The uncertainty is a simple(ish) call… do you think the toy will end up inside or outside the
circle?
Correct Call
Incorrect Call
Coin
0
You get to make the call “inside” or “outside” after the toy has been wound up and allowed to run
Unfortunately, we can only offer this investment opportunity to one person
We will sell this bond certificate to the highest bidder…
1. The selected person plays the game once.
2. The highest bidder will purchase the right to play the game – no collusion between bidders.
3. Payment is cash or cheque; no refunds.
“Random Walk” game rules
VISA MasterCard
6. If the call is correct, the person wins the coin.
7. If the call is incorrect, the person wins nothing.
8. I keep the amount paid to play, regardless of the outcome.
4. I will “release” the wind up toy.
5. The person calls: “Inside the circle” or “Outside the circle”. NB: Should any part of the toy be touching or outside the line, the toy is “outside the circle”.
On your bid card please can you write…
Your Name(so we can identify you!)
Your bid in £(i.e. how much you are willing to pay for the
bond certificate)
How much the coin is worth to you
Your Name(so we can identify you!)
Your bid in £(i.e. how much you are willing to pay for the
bond certificate)
How much the coin is worth to you
The certificate acknowledges the first important “decision” of this session
We define a decision as an “irrevocable” allocation of resources with the purpose of achieving a desired objective.
Probabilities quantify the person’s judgment about the likelihood of winning
Correct Call
Incorrect Call
Probability = p
Probability = 1 – p
Probability is a measure of a person’s degree of belief in a proposition based on all their previous information and
knowledge (including theoretical postulations).
The decision has now been made, so the amount bid is a sunk cost; that’s behind us now!
Invest
Don’t Invest
Decision
0
–£ Bid
Correct Call
Incorrect Call
Uncertainty Outcome
Coin
0
p =
1 – p =
Correct Call
Incorrect Call
Outcome
Coin
0
p =
1 – p =
Deal
To evaluate if the decision was a good one, we must establish a value for the deal
?
Keep
Sell
Decision
Correct Call
Incorrect Call
Uncertainty Outcome
0
p =
1 – p =
What is your minimum selling price?
The value of the deal is the person’s minimum selling price or “Certain Equivalent”
The person is indifferent between having the deal or its Certain Equivalent.
Correct Call
Incorrect Call
Uncertainty Outcome
Coin
0
p =
1 – p =
Deal
CertainEquivalent
It is important to recognise that good decisions are not the same as good outcomes
Preferred Results
Good Outcomes
What we would like!
Balances the probabilities of good and bad outcomes
consistent with preferences
Good Decisions
40
–6
15
4
.6
.4
.7
.3
What we need to do!
Another way to value the deal is to calculate its “Expected Value” (probability-weighted average)
The Expected Value (or “mean”) is the average return from each game if it were repeated many times.
Correct Call
Incorrect Call
Uncertainty Outcome
V
0
p =
1 – p =
Deal
EV = p x V + (1 – p) x 0
ExpectedValue(Value of coin)
The difference between “Expected Value” and “Certain Equivalence” reflects attitude
towards risk
This is a matter of preference; there is no “correct” risk attitude for your personal decisions. However, large commercial organisations would be well advised to generally make risk neutral decisions.
£
RiskAverse
RiskNeutral
RiskPreferring
EV
Risk Attitude
Certain Equivalents
Risk aversion should only become important if the decision involves outcomes that are large
in relation to your wealth
Risk averse people tend to risk neutrality when they feel the stakes are small.
Risk averse people tend to risk neutrality when they feel the stakes are small.
Jnr manager
Middle manager
Snr manager
Cer
tain
E
qu
ival
ence
Expected Value
Risk neutral line (CE = EV)
What is your call?
Inside the Circle? Outside the Circle?
Several insights emerge from the demonstration
• A decision is an irrevocable allocation of resources.
• Probability is the quantitative language for communicating about uncertainty.
• Probabilities represent judgment, which includes experience and information.
• The value of an uncertain deal depends on its characteristics and one’s attitude toward risk.
• We must distinguish between the quality of the decision and its outcome.
• Achieving alignment as a group is an additional challenge.
Correct Call
Incorrect Call
Correct Call
Incorrect Call
Probability = p
Probability = 1 – p
€
RiskAverse
RiskAverse
RiskNeutral
RiskNeutral
RiskPreferring
RiskPreferring
EV
Risk Attitude
Certain Equivalents