Decision Making Under Uncertainty Think Clearly – Act Decisively – Feel Confident Whats 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 (

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?

Lets create the most simple decision we can… Invest Dont Invest Decision – £ X Decision Good Bad 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: Krugerrands are legal tender in South Africa. The coin has a face value of ~ £ Source: Spot price for 1 troy ounce of gold is US$ 945 Source:

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 persons judgment about the likelihood of winning Correct Call Incorrect Call Probability = p Probability = 1 – p Probability is a measure of a persons 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; thats behind us now! Invest Dont Invest Decision 0 –£ Bid Correct Call Incorrect Call UncertaintyOutcome 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 UncertaintyOutcome 0 p = 1 – p = What is your minimum selling price?

The value of the deal is the persons minimum selling price or Certain Equivalent The person is indifferent between having the deal or its Certain Equivalent. Correct Call Incorrect Call UncertaintyOutcome Coin 0 p = 1 – p = Deal Certain Equivalent

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 – 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 UncertaintyOutcome V 0 p = 1 – p = Deal EV = p x V + (1 – p) x 0 Expected Value (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. £ Risk Averse Risk Neutral Risk Preferring 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. Jnr manager Middle manager Snr manager Certain Equivalence 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 ones attitude toward risk. We must distinguish between the quality of the decision and its outcome. Achieving alignment as a group is an additional challenge.