Decision Models

Making Decisions Under Risk

Decision Making Under Risk

When doing decision making under uncertainty, we assumed we had no idea about which state of nature would occur. In decision making under risk, we assume we have some idea (by experience, gut feel, experiments, etc.) about the likelihood of each state of nature occurring.

The Expected Value Approach

Given a set of probabilities for the states of nature, p1, p2 etc., for each decision an expected payoff can be calculated by: pi(payoffi) If this is a decision that will be repeated over and over again, the decision with the highest expected payoff should be the one selected to maximize total expected payoff. But if this is a one-time decision, perhaps the risk of losing much money may be too great -thus the expected payoff is just another piece of information to be considered by the decision maker.

Expected Value Decision

Suppose the broker has offered his own projections for the probabilities of the states of nature:
P(S1) = .2, P(S2) = .3, P(S3) = .3, P(S4) = .1, P(S5) = .1
Probability

.2 .3 .3 .1 .1 S1 S2 S3 S4 S5 Expected Value Lg Rise Sm Rise No Chg. Sm Fall Lg Fall .2(-100)+.3(100)+ D1: Gold -$100 $100 $200 $300 $0 $100 .3(200)+.1(300)+.1(0) .2(250)+.3(200)+.3(150) D2: Bond $250 $200 $150 -$100 -$150 +.1(-100)+.1(-150) $130 D3: Stock D4: C/D $500 $60 $250 $60 $100 $60 -$200 $60 -$600 $60

.2(500)+.3(250)+.3(100) $125 +.1(-200)+.1(-600) .2(60)+.3(60)+.3(60) $60 +.1(60)+.1(60)

Highest -- Choose D2 - Bond

Perfect Information
Although the states of nature are assumed to occur with the previous probabilities, suppose you knew, each time which state of nature would occur -- i.e. you had perfect information Then when you knew S1 was going to occur, you would make the best decision for S1 (Stock = $500). This would happen p1 = .2 of the time. When you knew S2 was going to occur, you would make the best decision for S2 (Stock = $250). This would happen p2 = .3 of the time. And so forth

Expected Value of Perfect Information (EVPI)

The expected value of perfect information (EVPI) is the gain in value from knowing for sure which state of nature will occur when, versus only knowing the probabilities. It is the upper bound on the value of any additional information.

Calculating the EVPI

Probability .2 .3 .3 .1 .1 S1 S2 S3 S4 S5 Lg Rise Sm Rise No Chg. Sm Fall Lg Fall D1: Gold -$100 $100 $200 $300 $0 D2: Bond $250 $200 $150 -$100 -$150 D3: Stock $500 $250 $100 -$200 -$600

D4: C/D

$60

$60

$60

$60

$60

Expected Return With Perfect Information (ERPI) = .2(500) + .3(250) + .3(200) + .1(300) + .1(60) = $271 Expected Return With No Additional Information = EV(Bond) = $130 Expected Value Of Perfect Information (EVPI) = ERPI - EV(Bond) = $271 - $130 = $141

Using the Decision Template

Enter Probabilities Expected Value Decision EVPI

Sample Information
One never really has perfect information, but can gather additional information, get expert advice, etc. that can indicate which state of nature is likely to occur each time. The states of nature still occur, in the long run with P(S1) = .2, P(S2) = .3, P(S3) = .3, P(S4) = .1, P(S5) = .1. We need a strategy of what to do given each possibility of the indicator information We want to know the value of this sample information (EVSI).

Sample Information Approach

Given the outcome of the sample information, we revise the probabilities of the states of nature occurring (using Bayesian analysis). Then we repeat the expected value approach (using these revised probabilities) to see which decision is optimal given each possible value of the sample information.

Example -- Samuelman Forecast

Noted economist Milton Samuelman gives an economic forecast indicating either Positive or Negative economic growth in the coming year. Using a relative frequency approach based on past data it has been observed:
P(Positive|large rise) = .8 P(Positive|small rise) = .7 P(Positive|no change)= .5 P(Positive|small fall) = .4 P(Positive|large fall) = 0 P(Negative|large rise) = .2 P(Negative|small rise) = .3 P(Negative|no change)= .5 P(Negative|small fall) = .6 P(Negative|large fall) = 1

Bayesian Probabilities Given a Positive Forecast

Prob(Positive) = P(Positive|Large Rise)P(Large P(Positive and Large Rise) + Rise) + (.80) (.20) P(Positive|Small Rise) P(Small P(Positive and Small Rise) + Rise) + (.70) (.30) P(Positive|No Change) + P(Positive andChange)P(No No Change) + (.50) (.30) P(Positive|Small Fall)Fall) P(Small P(Positive and Small + Fall) + (.40) (.10) P(Positive|Large Fall)Fall) P(Large P(Positive (0) and Large = .56 (.10) Fall)
P(Large Rise|Pos) P(Small Rise|Pos) P(No Change|Pos) P(Small Fall|Pos) P(Large Fall|Pos) = P(Pos|Lg. (.80) Rise)P(Lg. (.20) Rise)/P(Pos) /.56 = .286 = P(Pos|Sm. (.70) Rise)P(Sm. (.30) Rise)/P(Pos) /.56 = .375 = P(Pos|No (.50) Chg.)P(No (.30) Chg.)/P(Pos) /.56 = .268 = P(Pos|Sm. (.40) Fall)P(Sm. (.10) Fall)/P(Pos) /.56 = .071 = P(Pos|Lg. (0) Fall)P(Lg. (.10) Fall)/P(Pos) /.56 = 0

Best Decision With Positive Forecast

Revised Probability

.286 .375 .268 .071 0 S1 S2 S3 S4 S5 Expected Value Lg Rise Sm Rise No Chg. Sm Fall Lg Fall D1: Gold -$100 $100 $200 $300 $0 $84 D2: Bond $250 $200 $150 -$100 -$150 $180 D3: Stock $500 $250 $100 -$200 -$600 $249 D4: C/D $60 $60 $60 $60 $60 $60

Highest With Positive Forecast -- Choose D3 - Stock

When Samuelman predicts positive -- Choose the Stock!

Bayesian Probabilities Given a Negative Forecast

Prob(Negative) = P(Negative P(Negative|Large Rise)P(Large and Large Rise) + Rise) + (.20) (.20) P(Negative|Small Rise) P(Small P(Negative and Small Rise) + Rise) + (.30) (.30) P(Negative|No Change) + P(Negative andChange)P(No No Change) + (.50) (.30) P(Negative|Small Fall)Fall) P(Small P(Negative and Small + Fall) + (.60) (.10) = .44 (1) (.10) Fall) P(Negative|Large Fall)Fall) P(Large P(Negative and Large
P(Large Rise|Neg) P(Small Rise|Neg) P(No Change|Neg) P(Small Fall|Neg) P(Large Fall|Neg) = P(Neg|Lg. (.20) Rise)P(Lg. (.20) Rise)/P(Neg) /.44 = .091 = P(Neg|Sm. (.30) Rise)P(Sm. (.30) Rise)/P(Neg) /.44 = .205 = P(Neg|No (.50) Chg.)P(No (.30) Chg.)/P(Neg) /.44 = .341 = P(Neg|Sm. (.60) Fall)P(Sm. (.10) Fall)/P(Neg) /.44 = .136 = P(Neg|Lg. (1) Fall)P(Lg. (.10) Fall)/P(Neg) /.44 = .227

Best Decision With Negative Forecast

Revised Probability

.091 .205 .341 .136 .227 S1 S2 S3 S4 S5 Expected Value Lg Rise Sm Rise No Chg. Sm Fall Lg Fall D1: Gold -$100 $100 $200 $300 $0 $120 D2: Bond $250 $200 $150 -$100 -$150 $ 67 D3: Stock $500 $250 $100 -$200 -$600 -$33 D4: C/D $60 $60 $60 $60 $60 $60

Highest With Negative Forecast -- Choose D1 - Gold

When Samuelman predicts negative -- Choose Gold!

Strategy With Sample Information

If the Samuelman Report is Positive - Choose the stock! If the Samuelman Report is Negative - Choose the gold!

Expected Value of Sample Information (EVSI)

Recall, P(Positive) = .56 P(Negative) = .44
When positive -- choose Stock with EV = $249 When negative -- choose Gold with EV = $120

Expected Return With Sample Information (ERSI) = .56 (249) + .44 (120) = $192.50 Expected Return With No Additional Information = EV(Bond) = $130 Expected Value Of Sample Information (EVSI) = ERSI - EV(Bond) = $192.50 - $130 = $62.50

Efficiency
Efficiency is a measure of the value of the sample information as compared to the theoretical perfect information. It is a number between 0 and 1 given by: Efficiency = EVSI/EVPI For the Jones Investment Model: Efficiency = 62.50/141 = .44

Using the Decision Template

Enter Conditional Probabilities

Bayesian Worksheet Results on Posterior Worksheet

Output -- Posterior Analysis

Indicator Probabilities Revised Probabilities Optimal Strategy EVSI, EVPI, Efficiency

Review
Expected Value Approach to Decision Making Under Risk EVPI Sample Information
Bayesian Revision of Probabilities P(Indicator Information) Strategy EVSI Efficiency

Use of Decision Template