Risk in decision making

When deciding among options, money is a major consideration

Risk can be brought into the equation through a higher discount rate, or by calculating the risk exposure as follows

Suppose we are thinking about ways of saving money:

 
60% x £100,000  £60,000 
10% x £120,000  £12,000 
20% x £80,000  £16,000 
10% x £60,000  £ 6,000 
Factored cost  £94,000 

This is less than original £100,000 because of the risk of small savings

Risk chart

Risk in decision making

Question: You are a manager in a cost-conscious organisation. Which option would you choose?

A. Save £100,000, but 40% probability of losing £10,000

B. Save £60,000, but 10% probability of saving only £1,000


Decision tree

You should produce a decision tree for the above problem

Decision tree

A:

(60% x £100,000) + (40% x -£10,000) = £60,000 - £4,000 = £56,000 saving

B:

(90% x £60,000) + (10% x £1000) = £54,000 + £100 = £54,100 saving

Which would you choose? Why?

 

(Move your mouse pointer over the icon for a suggestion)
Mathematically option A, but option B won't make a loss, so looks safer to me


Risk in decision making

Question: Which option would you choose?

Three curves

 


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