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