Chapter – 9
Risk and Uncertainty
Risk vs. Uncertainty
Risk Uncertainty
A situation where a number of possible A situation where a number of possible
outcomes exist and the probability of outcomes exists but the probability of
each outcome is known. each outcome is not known.
Market research techniques for assessing and reducing uncertainty
Research techniques for reducing uncertainty
Focus Groups Desk research Field research
(Secondary (Primary
Research) Research)
Motivational Measurement
research research
Focus Groups
A market research tool where small groups of 8-10 people are selected from a broader population.
The group is interviewed by a facilitator in an informal environment to gather their opinions and
reactions on a particular subject.
Problems with focus groups
❑ Results are qualitative
❑ Results may not be representative because
of the small sample size
❑ Individuals may feel under pressure to agree
with other members or to give a 'right'
answer
❑ They are costly and logistically complex
Desk Research
Here the information is collected from secondary sources by studying published and other available
sources of information. It leads to eliminating extensive field work but may not give what the researcher
wants and may not be totally up to date or accurate.
Types of information that can be collected by desk research
Economic intelligence Market intelligence Internal company data
Information relating to economic Information about a company’s
environment within which a present or possible future
company operates. markets.
It includes knowing about the It includes both commercial and
GNP, investment, expenditure, technical information.
population, employment,
productivity and trade.
Field Research
Here information is collected from primary sources by direct contact with a targeted group of people.
It is very expensive and time consuming but the results it gives, are too accurate, relevant and up to date.
Types of field research
Motivational research Measurement research
Conducted to understand the factors Done to build on the motivation research
that influence why consumers do or by quantifying the issues.
do not buy particular products.
Sample surveys are used to find out how
many people buy the product, what quantity
each type of buyer purchases, and where
and when the product is bought.
Field Research
Motivational research techniques
Depth interviewing
Done in detail by a trained
person who is able to Group interviewing
appreciate conscious and
unconscious associations Done under trained
and motivations and their supervision, with 6-10 Word association testing
significance. people are interviewed
about the relevant On being given a word Triad testing
subject (object). by the interviewer, the
first word that comes Here people are asked
into the mind of the which out of a given
person being tested is three items they would
noted. prefer. The replies can
give the details about the
features of a product
which influence the
buying decision.
Field Research
Types of measurement research
Random sampling Panelling Observation
Where each person in the target Where the sample is kept for Done by observing any particular
population has an equal chance of subsequent investigations, attribute or aspect under study. For
being selected. Such samples are so trends are easier to spot. e.g. observing in a school reception
more likely to be representative, area, how long parents of perspective
making predictions more reliable. students spend on reading the school
However, the technique may be prospectus and display boards.
unfeasible in practice.
Quota sampling Surveying by post
Where samples are designed to It is a the mail shot method.
be representative with respect This also suffers from biasness
to pre-selected criteria. Its main because the sample can be
disadvantage is that samples self selected.
may be biased for non-selected
criteria.
Other methods of dealing with risk and uncertainty
1. Sensitivity analysis
2. Simulation
3. Expected values
4. Maximax, maximin and minimax regret
5. Decision Trees
Sensitivity Analysis
Sensitivity analysis: Majorly, it involves posing 'what-if' questions. It takes into account, each uncertain factor to
calculate the change that would be necessary in that factor before the original decision is reversed. The maximum
possible change is often expressed as a percentage. This method can only works for total cash flows. It cannot be
used for individual units, selling prices, variable cost per unit, etc.
Strengths of sensitivity analysis Weaknesses of sensitivity analysis
• It is simple to understand. • It assumes that changes to variables can be
• Information is presented to management in a made independently. Simulation allows us to
form which facilitates subjective judgement to change more than one variable at a time.
decide the likelihood of the various possible • It only identifies how far a variable needs to
outcomes considered. change; it does not look at the probability of
• It identifies areas which are crucial to the such a change.
success of the project. • It provides information on the basis of which
decisions can be made but it does not point to
the correct decision directly.
Simulation
Simulation is a modelling technique which shows the effect of more than one variable changing at the same time. It
is mostly used in capital investment appraisal.
The Monte Carlo simulation method: Random numbers and probability statistics are used here to include all
random events which can affect the success of a project. The model identifies key variables in a decision which
can be costs and revenues.
Random numbers are then assigned to each variable in a proportion in accordance with the underlying probability
distribution.
A powerful computer is then used to repeat the decision many times and give management a view of the likely
range and level of outcomes.
Drawbacks of simulation:
• It is not a decision making technique. It only
provides more information about the possible
outcomes.
• Theses models can become extremely complex.
• The time and costs involved in the construction
of models can be more than the results gained
• Formulation of probability distributions can be
difficult.
Expected Values
Expected value (‘EV’) is a weighted average of all possible outcomes to calculate the average return that will be
made if a decision is repeated again and again. It shows the average outcome of a decision in long run, which
makes it a useful decision rule for a risk neutral decision maker.
EV = Σpx
Who is a risk neutral decision maker?
One who neither seeks risk nor avoids it, rather he/she accepts an average result.
Advantages of EVs Disadvantages of EVs:
❑ It takes uncertainty into account by considering ❑ The probabilities used are very subjective.
the probability of each possible outcome ❑ This method gives a weighted average value
❑ The information is reduced to a single number which cannot be applied to a one-off project.
resulting in easier decisions. ❑ The EV gives no indication of the dispersion of
❑ The method and calculations are relatively possible outcomes about the EV, i.e. the risk.
simple. ❑ The EV may not correspond to any of the actual
possible outcomes
Pay–Off Tables
A profit table (pay-off table) represents a scenario having various possible outcomes with various
possible responses. It illustrates all possible profits/losses and makes the analysis of a decision easy.
Maximax, Maximin and Minimax Regret
These techniques are used when probabilities are not available and it is essential to incorporate uncertainty into
decision making.
The Maximax Rule: Selecting the alternative which maximises the maximum pay-off achievable. This approach is
used by an optimist, or 'risk-seeking' investor, who wants to achieve the best results if the best happens
The Maximin Rule: Selecting the alternative which maximises the minimum pay-off achievable. This approach is
used by a risk-averse pessimist who wants to achieve the best results, if the worst happens. He chooses the
outcome which is guaranteed to minimise his losses.
But in the process, he loses the opportunity of making big profits.
The Minimax Regret rule: ‘Regret’ is the opportunity loss incurred because of making the wrong decision. Under
this rule, a risk-averse decision maker minimises the maximum regret. It is a technique for a ’sore loser’ who
does not wish to make the wrong decision.
Decision Tree
It is a diagrammatic representation of a multi-decision problem, where all possible courses of action are
represented, and every possible outcome of each course of action is shown.
Where is a decision tree used??
Where a problem involves a series of decisions and several outcomes arising during the decision-
making process.
How is a decision tree constructed??
➢ A logical sequence of events is considered in a complex problem
➢ The problem is broken down into smaller, easier to handle sections.
➢ The financial outcomes and probabilities are shown separately, and the decision tree is ‘rolled
back’ by calculating expected values and making decisions.
Value of information
What is ‘perfect information’?
The forecast of the future outcome is always a correct prediction. If a firm obtains a 100% accurate
prediction, then it will be able to take the most beneficial course of action based on that prediction.
What is ‘imperfect information’?
The forecast is usually correct, but can be incorrect also. It is not as valuable as perfect information.
Thus,
Value of information = Expected profit with the information
Less: Expected profit without the information
Thank You