1.040/1.

401
Project Management
Spring 2006

Risk Analysis
Decision making under risk and uncertainty

Department of Civil and Environmental Engineering

Massachusetts Institute of Technology
 Preliminaries
Announcements
Remainder
email Sharon Lin the team info by midnight, tonight
Monday Feb 27 - Student Experience Presentation
Wed March 1st Assignment 2 due
Today, recitation Joe Gifun, MIT facility
Next Friday, March 3rd, Tour PDSI construction site
1st group noon 1:30
2nd group 1:30 3:00
Construction nightmares discussion
16 - Psi Creativity Center, Design and Bidding
phases
Project Management Phase

FEASIBILITY DESIGN DEVELOPMENT CLOSEOUT OPERATIONS

PLANNING

Financing&Evalua
tion
Risk
Analysis&Attitude
 Risk Management Phase

FEASIBILITY DESIGN DEVELOPMENT CLOSEOUT OPERATIONS

PLANNING

RISK MNG
Risk management (guest seminar 1st wk April)
Assessment, tracking and control
Tools:
Risk Hierarchical modeling: Risk breakdown structures
Risk matrixes
Contingency plan: preventive measures, corrective actions,
risk budget, etc.
 Decision Making Under
Risk Outline
Risk and Uncertainty
Risk Preferences, Attitude and
Premiums
Examples of simple decision trees
Decision trees for analysis
Flexibility and real options
Decision making
 Uncertainty and Risk
risk as uncertainty about a
consequence
Preliminary questions
What sort of risks are there and who
bears them in project management?
What practical ways do people use to
cope with these risks?
Why is it that some people are willing to
take on risks that others shun?
 Some Risks
Weather changes Community opposition
Different productivity Infighting &
(Sub)contractors are acrimonious
Unreliable relationships
Lack capacity to do work Unrealistically low bid
Lack availability to do Late-stage design
work changes
Unscrupulous
Financially unstable
Unexpected subsurface
conditions
Late materials delivery Soil type
Lawsuits Groundwater
Labor difficulties Unexpected Obstacles
Unexpected Settlement of adjacent
manufacturing costs structures
Failure to find High lifecycle costs
sufficient tenants Permitting problems

 Importance of Risk
Much time in construction
management is spent focusing on risks
Many practices in construction are
driven by risk
Bonding requirements
Insurance
Licensing
Contract structure
General conditions
Payment Terms
Delivery Method
Selection mechanism
 Outline
Risk and Uncertainty
Risk Preferences, Attitude and
Premiums
Examples of simple decision trees

Decision trees for analysis

Flexibility and real options

Decision making under risk
Available Techniques
Decision modeling
Decision making under uncertainty
Tool: Decision tree

Strategic thinking and problem

solving:
Dynamic modeling (end of course)
Fault trees
Introduction to Decision
Trees
We will use decision trees both for
Illustrating decision making with
uncertainty
Quantitative reasoning

Represent
Flow of time
Decisions

Uncertainties (via events)

Consequences (deterministic or stochastic)

 Decision Tree Nodes
Time

Decision (choice) Node

Chance (event) Node

Terminal (consequence) node

Outcome (cost or benefit)
 Risk Preference
People are not indifferent to uncertainty
Lack of indifference from uncertainty arises
from uneven preferences for different outcomes
E.g. someone may
dislike losing $x far more than gaining $x
value gaining $x far more than they disvalue losing

$x.
Individuals differ in comfort with
uncertainty based on circumstances and
preferences
Risk averse individuals will pay risk
premiums to avoid uncertainty
 Risk preference
The preference depends on decision maker
point of view
 Categories of Risk
Attitudes
Risk attitude is a general way of
classifying risk preferences
Classifications
Risk averse fear loss and seek sureness
Risk neutral are indifferent to uncertainty
Risk lovers hope to win big and dont
mind losing as much
Risk attitudes change over
Time
Circumstance
 Decision Rules
The pessimistic rule (maximin = minimax)
The conservative decisionmaker seeks to:
maximize the minimum gain (if outcome = payoff)
or minimize the maximum loss (if outcome = loss, risk)
The optimistic rule (maximax)
The risklover seeks to maximize the maximum
gain
Compromise (the Hurwitz rule):
Max ( min + (1- ) max) , 0 1
= 1 pessimistic
= 0.5 neutral
= 0 optimistic
The bridge case unknown
probties
$ 1.09 million
replace

$1.61 M

repair
$0.55 Investment PV

$1.43
Pessimistic rule
min (1, 1.61) = 1 replace the bridge
The optimistic rule (maximax)
max (1, 0.55) = 0.55 repair and hope it
works!
 The bridge case known
probties
$ 1.09 million
replace

$1.61 M
0.25
repair 0.5
$0.55 Investment PV
0.25
$1.43

Expected monetary value

E = (0.25)(1.61) + (0.5)(0.55) + (0.25)(1.43) =
$ 1.04 M

Data link
 The bridge case
decision
The pessimistic rule (maximin =
minimax)
Min(Ei) = Min (1.09 , 1.04) = $
1.04 repair
In this case = optimistic rule
(maximax)
Awareness of probabilities change
risk attitude
 Other criteria
Most likely value
For each policy option we select the
outcome with the highest probability
Expected value of Opportunity Loss
 To buy soon or to buy later
-100
Buy soon

Buy later -100-30+5 = -125

-100+5 = -95

-100+5+30 = -65

Current price = 100

S1 = + 30%
S2 = no price variation
S3 = - 30%

Actualization = 5
To buy soon or to buy later
-100
Buy soon

Buy later -125

0. 5
0.25
-95
0.25
-65
 The Utility Theory
When individuals are faced with uncertainty they
make choices as is they are maximizing a given
criterion: the expected utility.

Expected utility is a measure of the individual's

implicit preference, for each policy in the risk
environment.

It is represented by a numerical value associated

with each monetary gain or loss in order to
indicate the utility of these monetary values to
the decision-maker.
 Adding a Preference
function
1.35

1
.7

125 100 65
Expected (mean) value
E = (0.5)(125) + (0.25)(95) + (0.25)(65) =
-102.5
Utility value:
f(E) = Pa * f(a) = 0.5 f(125) + 0.25 f(95) + .
25 f(65) =
 Defining the Preference
Function
Suppose to be awarded a $100M
contract price
Early estimated cost $70M

What is the preference function of

cost?
utility

Preference means utility or satisfaction

70 $
 Notion of a Risk
Premium
A risk premium is the amount paid by a
(risk averse) individual to avoid risk
Risk premiums are very common what
are some examples?
Insurance premiums
Higher fees paid by owner to reputable

contractors
Higher charges by contractor for risky work

Lower returns from less risky investments

Money paid to ensure flexibility as guard

against risk
Conclusion: To buy or not
to buy
The risk averter buys a future
contract that allow to buy at $ 97.38
The trading company (risk lover) will
take advantage/disadvantage of
future benefit/loss
 Certainty Equivalent
Example
Consider a risk averse individual with
preference fn f faced with an
investment c that provides Mean satisfaction with
investment
50% chance of earning $20000 .50

50% chance of earning $0 .25

Average money from investment = Certainty equi

of investment
.5*$20,000+.5*$0=$10000
Average satisfaction with the
investment= Mean valu
.5*f($20,000)+.5*f($0)=.25 Of investm

This individual would be willing to

$5000
trade for a sure investment yielding
satisfaction>.25 instead
Can get .25 satisfaction for a sure f -
1(.25)=$5000

We call this the certainty equivalent to the

investment
Therefore this person should be willing to
trade this investment for a sure amount of
money>$5000
 Example Contd (Risk
Premium)
The risk averse individual would be willing

to trade the uncertain investment c for any

certain return which is > $5000
Equivalently, the risk averse individual
would be willing to pay another party an
amount r up to $5000 =$10000-$5000 for
other less risk averse party to guarantee
$10,000
Assuming the other party is not risk averse,
that party wins because gain r on average
The risk averse individual wins b/c more

satisfied
 Certainty Equivalent
More generally, consider situation in which have
Uncertainty with respect to consequence c
Non-linear preference function f
Note: E[X] is the mean (expected value) operator
The mean outcome of uncertain investment c is E[c]
In example, this was .5*$20,000+.5*$0=$10,000
The mean satisfaction with the investment is E[f(c)]
In example, this was .5*f($20,000)+.5*f($0)=.25
We call f-1(E[f(c)]) the certainty equivalent of c
Size of sure return that would give the same satisfaction
as c
In example, was f-1(.25)=f-1(.5*20,000+.5*0)=$5,000
 Risk Attitude Redux
The shapes of the preference functions
means can classify risk attitude by
comparing the certainty equivalent and
expected value
For risk loving individuals, f-1(E[f(c)])>E[c]
They want Certainty equivalent > mean outcome
For risk neutral individuals, f-1(E[f(c)])=E[c]
For risk averse individuals, f-1(E[f(c)])<E[c]
 Motivations for a Risk
Premium
Consider
Risk averse individual A for whom f-
1(E[f(c)])<E[c]

Less risk averse party B

A can lessen the effects of risk by paying a

risk premium r of up to E[c]-f-1(E[f(c)]) to
B in return for a guarantee of E[c] income
The risk premium shifts the risk to B
The net investment gain for A is E[c]-r, but A

is more satisfied because E[c] r > f -1(E[f(c)])

B gets average monetary gain of r
Gamble or not to Gamble

EMV
(0.5)(-1) + (0.5)(1) = 0

Preference function f(-1)=0, f(1)=100

Certainty eq. f-1(E[f(c)]) = 0
No help from risk analysis !!!!!
 Multiple Attribute
Decisions
Frequently we care about multiple
attributes
Cost
Time

Quality

Relationship with owner

Terminal nodes on decision trees can

capture these factors but still need to
make different attributes comparable
 The bridge case - Multiple
tradeoffs
Computation of Pareto-Optima
For decision D2

Replace
MTTF 10.0000
Cost 1.00

C3
MTTF 6.6667
Cost 0.30

C4
MTTF 5.7738
Cost 0.00
Aim: maximizing bridge duration, minimizing cost

MTTF = mean time to failure

 Pareto Optimality
Even if we cannot directly weigh one attribute
vs. another, we can rank some consequences
Can rule out decisions giving consequences
that are inferior with respect to all attributes
We say that these decisions are dominated by
other decisions
Key concept here: May not be able to identify
best decisions, but we can rule out obviously
bad
A decision is Pareto optimal (or efficient
solution) if it is not dominated by any other
decision
 03/06/06 - Preliminaries
Announcements
Due dates Stellar Schedule and not Syllabus
Term project
Phase 2 due March 17th
Phase 3 detailed description posted on Stellar, due May 11
Assignment PS3 posted on Stellar due date March
24
Decision making under uncertainty
Reading questions/comments?
Utility and risk attitude
You can manage construction risks
Risk management and insurances - Recommended
 Decision Making Under
Risk
Risk and Uncertainty
Risk Preferences, Attitude and
Premiums
Examples of simple decision trees

Decision trees for analysis

Flexibility and real options

 Multiple objective
The students dilemma
 Decision Making Under
Risk
Risk and Uncertainty
Risk Preferences, Attitude and
Premiums
Examples of simple decision trees

Decision trees for analysis

Flexibility and real options

 Bidding
What choices do we have?
How does the chance of winning
vary with our bidding price?
How does our profit vary with our
bidding price if we win?
Example Bidding
Decision Tree
Time
Bidding Decision Tree with
Stochastic Costs,
Competing Bids
Selecting Desired Electrical
Capacity
 Decision Tree Example:
Procurement Timing
Decisions
Choice of order time (Order early, Order
late)
Events
Arrival time (On time, early, late)
Theft or damage (only if arrive early)

Consequences: Cost
Components: Delay cost, storage cost,
cost of reorder (including delay)
Procurement Tree
 Decision Making Under
Risk
Risk and Uncertainty
Risk Preferences, Attitude and
Premiums
Decision trees for representing
uncertainty
Decision trees for analysis

Flexibility and real options

 Analysis Using Decision
Trees
Decision trees are a powerful
analysis tool
Example analytic techniques
Strategy selection (Monte Carlo
simulation)
One-way and multi-way sensitivity
analyses
Value of information
Recall Competing Bid Tree
 Monte Carlo simulation
Monte Carlo simulation randomly generates values for
uncertain variables over and over to simulate a model.
It's used with the variables that have a known range of
values but an uncertain value for any particular time or
event.
For each uncertain variable, you define the possible
values with a probability distribution.
Distribution types include:

A simulation calculates multiple scenarios of a model
by repeatedly sampling values from the probability
distributions
Computer software tools can perform as many trials (or
scenarios) as you want and allow to select the optimal
strategy
Monetary Value of
$6.75M Bid
Monetary Value of $7M
Bid
With Risk Preferences:
6.75M
With Risk Preferences:
7M
Larger Uncertainties in
Cost
(Monetary Value)
Large Uncertainties II
(Monetary Values)
With Risk Preferences for
Large Uncertainties at
lower bid
With Risk Preferences for
Higher Bid
Optimal Strategy
 Decision Making Under
Risk
Risk and Uncertainty
Risk Preferences, Attitude and
Premiums
Decision trees for representing
uncertainty
Examples of simple decision trees

Decision trees for analysis

Flexibility and real options

 Flexibility and Real
Options
Flexibility is providing additional
choices
Flexibility typically has
Value by acting as a way to lessen the
negative impacts of uncertainty
Cost
Delaying decision
Extra time

Cost to pay for extra fat to allow for

flexibility
 Ways to Ensure of
Flexibility
in Construction
Alternative Delivery
Contingent plans for
Clear spanning (to
Value engineering
Geotechnical conditions
allow movable walls) Procurement strategy
Extra utility Additional elevator
conduits (electricity, Larger electrical
phone,) panels
Larger footings & Property for expansion
columns Sequential
Broader foundation construction
Alternative Wiring to rooms
heating/electrical
 Adaptive Strategies
An adaptive strategy is one that
changes the course of action based
on what is observed i.e. one that
has flexibility
Rather than planning statically up front,
explicitly plan to adapt as events unfold
Typically we delay a decision into the
future
 Real Options
Real Options theory provides a means of
estimating financial value of flexibility
E.g. option to abandon a plant, expand bldg
Key insight: NPV does not work well with
uncertain costs/revenues
E.g. difficult to model option of abandoning
invest.
Model events using stochastic diff.
equations
Numerical or analytic solutions
Can derive from decision-tree based framework
Example: Structural Form
Flexibility
 Considerations
Tradeoffs
Short-term speed and flexibility
Overlapping design & construction and different
construction activities limits changes
Short-term cost and flexibility
E.g. value engineering away flexibility
Selection of low bidder
Late decisions can mean greater costs
NB: both budget & schedule may ultimately be
better off w/greater flexibility!
Frequently retrofitting $ > up-front $
 Decision Making Under
Risk
Risk and Uncertainty
Risk Preferences, Attitude and
Premiums
Decision trees for representing
uncertainty
Examples of simple decision trees

Decision trees for analysis

Flexibility and real options

 Readings
Required
More information:
Utility and risk attitude Stellar Readings
section
Get prepared for next class:
You can manage construction risks Stellar
On-line textbook, from 2.4 to 2.12

Recommended:
Meredith Textbook, Chapter 4 Prj
Organization
Risk management and insurances Stellar
 Risk - MIT libraries
Haimes, Risk modeling, assessment, and management

Mun, Applied risk analysis : moving beyond uncertainty

Flyvbjerg, Mega-projects and risk

Chapman, Managing project risk and uncertainty : a

constructively simple approach to decision making

Bedford, Probabilistic risk analysis: foundations and

methods

and a lot more!