introduction to a decision tree approach to business and litigation decision making

34 Coquito Court, Menlo Park • California 94028 • Phone 650.854.1914 • www.litigationriskmanagement.com • [email protected]

LitigationRisk Management

Institute

Bruce Beron, Ph.D., President

Introduction to Our Approach to Business & Litigation Decision-Making

Risk ManagementLitigation

Institute© Bruce Beron 2014 Basis/Intro LRM

• This is a quantitative approach.• Based on decision and risk analysis.

• Uses explicit quantitative probability judgments• Risk is taken into account by the use of probability

• First, let’s look at a few basic concepts that we use.

The objective of this presentation is to present the underpinnings of a decision analytic framework.

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• Few lawyers or business people understand Risk.• Requires a statement of likelihood like:

• Could• Might• Will• Or, most effectively, a probability (quantitative)

• And requires a statement of consequence• Hit by a car• Lose our shirts• Or, most effectively, lose ten million dollars (quantitative)

The art of business-like decision-making is the art of balancing risk and reward.

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• We almost always focus on the risks, the downside.• There is someone’s name on the check.• The accounting system knows exactly how much was spent or

misspent.• The potential upsides are never precise or well defined.

• Very few people get fired for increasing sales by 30% when they should have increased them by 40%.

• Very few attorneys are criticized for settling a case for $20M when the expected loss was $10M.

• The upside too requires a statement of likelihood and a statement of consequence.

Most attorneys and business people do not think properly about the rewards either.

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• The probabilities are of unique, one-time events.• There is no right answer to a probability judgment.

• The question we want answered is, “Will we win or lose the case?”• For this question there is a correct answer, either “Yes” or “No”

— we just don’t know which.• If you assign a probability of .05 to an event and it happens, it does

not mean that the .05 was wrong.• These probabilities are different from the likelihood of throwing a 7

with a pair of dice — which can be right or wrong.

• The best we can do is make a explicit, quantified judgments as to the likelihood of events.

The probabilities we use here are a quantification of judgments, based on knowledge and experience.

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• Words don’t work.• Extensive tests show they are ambiguous.

• For one person, very likely means 90-100%, while to another it may mean 60-70%

• We must combine several uncertainties to come to a decision.• We can’t do that with words, but we can with likelihoods expressed

as numbers - probabilities.• Probabilities change with new knowledge.

• They shouldn’t change much unless something extreme or unlikely happens that could influence our judgment.

• Quantification does not imply precision.• We are quantifying these numbers to be unambiguous and to

allow us to combine judgments to come to a decision, not because we are trying to be overly precise.

The probabilities we use here are a quantification of judgments, based on knowledge and experience (continued).

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• Think of it as a probability weighted average.• Expected Value represents the average value—

if you could play many times.• We define Expected Value as the sum over all the outcomes of

each outcome times its respective probability.• Usually derived with the use of decision trees.

Our decision criterion will be the Expected* Net Present Value of monetary results.

*Also know as Mean Net Present Value

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• If we are Defendants, any settlement amount less than the Reservation Price plus our expected future legal costs and fees is a good deal.• If the best settlement demand is significantly more than that,

we should be willing to take our chances at trial.• If we are Plaintiffs, any settlement amount more than the

Reservation Price minus our expected future legal costs and fees is a good deal.• If the best settlement offer is significantly less than that, we

should be willing to take our chances at trial.• The Reservation Price and future costs and fees are the basis

for the Litigate or Settle Decision.

The Mean or Expected Value represents your Reservation Price for the litigation.

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• A Good Decision is one that is consistent with our best available knowledge and preferences

• A Good Outcome is one that we want.

• It is very helpful to know explicitly what you can control and what you can't.

It is also important to distinguish between decisions and outcomes.

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• If you don't analyze decisions, you can only judge outcomes.• If you judge people on outcomes, they will make decisions that

have the least chance of a bad outcome, not the highest mean outcome.

• The best we can do is make good decisions.• We can’t control the outcomes.

• Good decisions can have bad outcomes.• Bad decisions can have good outcomes.

• Don’t be hard on yourself if you make a good decision and get a bad outcome!

It is also important to distinguish between decisions and outcomes (continued).

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introduction to a decision tree approach to business and litigation decision making

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