Decision making


Published on

Published in: Education, Technology
1 Like
  • Be the first to comment

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Decision making

  1. 1. Introduction to Decision MakingRobert HarrisVersion Date: December 2, 2009Previous versions: October 17, 2008; July 2, 1998We all make decisions of varying importance every day, so the idea that decision making can be a rather sophisticated art may at firstseem strange. However, studies have shown that most people are much poorer at decision making than they think. An understandingof what decision making involves, together with a few effective techniques, will help produce better decisions.What is Decision Making?Some DefinitionsA good place to start is with some standard definitions of decision making.1. Decision making is the study of identifying and choosing alternatives based on the values and preferences of the decisionmaker.Making a decision implies that there are alternative choices to be considered, and in such a case we want not only to identify as manyof these alternatives as possible but to choose the one that (1) has the highest probability of success or effectiveness and (2) best fitswith our goals, desires, lifestyle, values, and so on.2. Decision making is the process of sufficiently reducing uncertainty and doubt about alternatives to allow a reasonable choiceto be made from among them. This definition stresses the information-gathering function of decision making. It should be notedhere that uncertainty is reduced rather than eliminated. Very few decisions are made with absolute certainty because completeknowledge about all the alternatives is seldom possible. Thus, every decision involves a certain amount of risk. If there is nouncertainty, you do not have a decision; you have an algorithm--a set of steps or a recipe that is followed to bring about a fixed result.Kinds of Decisions
  2. 2. There are several basic kinds of decisions.1. Decisions whether. This is the yes/no, either/or decision that must be made before we proceed with the selection of an alternative.Should I buy a new TV? Should I travel this summer? Decisions whether are made by weighing reasons pro and con. The PMItechnique discussed in the next chapter is ideal for this kind of decision.It is important to be aware of having made a decision whether, since too often we assume that decision making begins with theidentification of alternatives, assuming that the decision to choose one has already been made.2. Decisions which. These decisions involve a choice of one or more alternatives from among a set of possibilities, the choice beingbased on how well each alternative measures up to a set of predefined criteria.3. Contingent decisions. These are decisions that have been made but put on hold until some condition is met.For example, I have decided to buy that car if I can get it for the right price; I have decided to write that article if I can work thenecessary time for it into my schedule. OR even, Well take the route through the valley if we can control the ridge and if we detect noenemy activity to the north.Most people carry around a set of already made, contingent decisions, just waiting for the right conditions or opportunity to arise.Time, energy, price, availability, opportunity, encouragement--all these factors can figure into the necessary conditions that need to bemet before we can act on our decision. Some contingent decisions are unstated or even exist below the awareness of the decisionmaker. These are the type that occur when we seize opportunity. We dont walk around thinking, "If I see a new laser printer for $38,Ill buy it," but if we happen upon a deal like that and we have been contemplating getting a new printer, the decision is made quickly.Decisions made in sports and warfare are like this. The best contingent and opportunistic decisions are made by the prepared mind--one that has thought about criteria and alternatives in the past.Decision Making is a Recursive ProcessA critical factor that decision theorists sometimes neglect to emphasize is that in spite of the way the process is presented on paper,decision making is a nonlinear, recursive process. That is, most decisions are made by moving back and forth between the choice ofcriteria (the characteristics we want our choice to meet) and the identification of alternatives (the possibilities we can choose fromamong). The alternatives available influence the criteria we apply to them, and similarly the criteria we establish influence thealternatives we will consider. Lets look at an example to clarify this.
  3. 3. Suppose someone wants to decide, Should I get married? Notice that this is a decision whether. A linear approach to decision makingwould be to decide this question by weighing the reasons pro and con (what are the benefits and drawbacks of getting married) andthen to move to the next part of the process, the identification of criteria (supportive, easy going, competent, affectionate, etc.). Next,we would identify alternatives likely to have these criteria (Kathy, Jennifer, Michelle, Julie, etc.). Finally we would evaluate eachalternative according to the criteria and choose the one that best meets the criteria. We would thus have a scheme like this:decision whether ... select criteria ... identify alternatives ... match criteria to alternatives ... make choiceHowever, the fact is that our decision whether to get married may really be a contingent decision. "Ill get married if I can find theright person." It will thus be influenced by the identification of alternatives, which we usually think of as a later step in the process.Similarly, suppose we have arrived at the "identify alternatives" stage of the process when we discover that Jennifer (one of the girlsidentified as an alternative) has a wonderful personality characteristic that we had not even thought of before, but that we now reallywant to have in a wife. We immediately add that characteristic to our criteria. Thus, the decision making process continues to moveback and forth, around and around as it progresses in what will eventually be a linear direction but which in its actual workings ishighly recursive.Key point, then, is that the characteristics of the alternatives we discover will often revise the criteria we have previouslyidentified.The Components of Decision MakingThe Decision EnvironmentEvery decision is made within a decision environment, which is defined as the collection of information, alternatives, values, andpreferences available at the time of the decision. An ideal decision environment would include all possible information, all of itaccurate, and every possible alternative. However, both information and alternatives are constrained because the time and effort togain information or identify alternatives are limited. The time constraint simply means that a decision must be made by a certain time.The effort constraint reflects the limits of manpower, money, and priorities. (You wouldnt want to spend three hours and half a tankof gas trying to find the very best parking place at the mall.) Since decisions must be made within this constrained environment, wecan say that the major challenge of decision making is uncertainty, and a major goal of decision analysis is to reduce uncertainty. Wecan almost never have all information needed to make a decision with certainty, so most decisions involve an undeniable amount ofrisk.
  4. 4. The fact that decisions must be made within a limiting decision environment suggests two things. First, it explains why hindsight is somuch more accurate and better at making decisions that foresight. As time passes, the decision environment continues to grow andexpand. New information and new alternatives appear--even after the decision must be made. Armed with new information after thefact, the hindsighters can many times look back and make a much better decision than the original maker, because the decisionenvironment has continued to expand.The second thing suggested by the decision-within-an-environment idea follows from the above point. Since the decision environmentcontinues to expand as time passes, it is often advisable to put off making a decision until close to the deadline. Information andalternatives continue to grow as time passes, so to have access to the most information and to the best alternatives, do not make thedecision too soon. Now, since we are dealing with real life, it is obvious that some alternatives might no longer be available if toomuch time passes; that is a tension we have to work with, a tension that helps to shape the cutoff date for the decision.Delaying a decision as long as reasonably possible, then, provides three benefits:1. The decision environment will be larger, providing more information. There is also time for more thoughtful and extended analysis.2. New alternatives might be recognized or created. Version 2.0 might be released.3. The decision makers preferences might change. With further thought, wisdom, and maturity, you may decide not to buy car X andinstead to buy car Y.And delaying a decision involves several risks:1. As the decision environment continues to grow, the decision maker might become overwhelmed with too much information andeither make a poorer decision or else face decision paralysis.2. Some alternatives might become unavailable because of events occurring during the delay. In a few cases, where the decision wasbetween two alternatives (attack the pass or circle around behind the large rock), both alternatives might become unavailable, leavingthe decision maker with nothing. And we have all had the experience of seeing some amazing bargain only to hesitate and find thatwhen we go back to buy the item, it is sold out.3. In a competitive environment, a faster rival might make the decision and gain advantage. Another manufacturer might bring asimilar product to market before you (because that company didnt delay the decision) or the opposing army might have seized thepass while the other army was "letting the decision environment grow."
  5. 5. The Effects of Quantity on Decision MakingMany decision makers have a tendency to seek more information than required to make a good decision. When too much informationis sought and obtained, one or more of several problems can arise. (1) A delay in the decision occurs because of the time required toobtain and process the extra information. This delay could impair the effectiveness of the decision or solution. (2) Informationoverload will occur. In this state, so much information is available that decision-making ability actually declines because theinformation in its entirety can no longer be managed or assessed appropriately. A major problem caused by information overload isforgetfulness. When too much information is taken into memory, especially in a short period of time, some of the information (oftenthat received early on) will be pushed out.The example is sometimes given of the man who spent the day at an information-heavy seminar. At the end of the day, he was not onlyunable to remember the first half of the seminar but he had also forgotten where he parked his car that morning.(3) Selective use of the information will occur. That is, the decision maker will choose from among all the information available onlythose facts which support a preconceived solution or position. (4) Mental fatigue occurs, which results in slower work or poor qualitywork. (5) Decision fatigue occurs where the decision maker tires of making decisions. Often the result is fast, careless decisions oreven decision paralysis--no decisions are made at all.The quantity of information that can be processed by the human mind is limited. Unless information is consciously selected,processing will be biased toward the first part of the information received. After that, the mind tires and begins to ignore subsequentinformation or forget earlier information. (Have you ever gone shopping for something where you looked at many alternatives--cars,knives, phones, TVs--only to decide that you liked the first one best?)Decision StreamsA common misconception about decision making is that decisions are made in isolation from each other: you gather information,explore alternatives, and make a choice, without regard to anything that has gone before. The fact is, decisions are made in a contextof other decisions. The typical metaphor used to explain this is that of a stream. There is a stream of decisions surrounding a givendecision, many decisions made earlier have led up to this decision and made it both possible and limited. Many other decisions willfollow from it.
  6. 6. Another way to describe this situation is to say that most decisions involve a choice from a group of preselected alternatives, madeavailable to us from the universe of alternatives by the previous decisions we have made. Previous decisions have "activated" or"made operable" certain alternatives and "deactivated" or "made inoperable" others.For example, when you decide to go to the park, your decision has been enabled by many previous decisions. You had to decide to livenear the park; you had to decide to buy a car or learn about bus routes, and so on. And your previous decisions have constrained yoursubsequent ones: you cant decide to go to a park this afternoon if it is three states away. By deciding to live where you do, you haveboth enabled and disabled a whole series of other decisions.As another example, when you enter a store to buy a DVD player or TV, you are faced with the preselected alternatives stocked by thestore. There may be 200 models available in the universe of models, but you will be choosing from, say, only a dozen. In this case,your decision has been constrained by the decisions made by others about which models to carry.We might say, then, that every decision (1) follows from previous decisions, (2) enables many future decisions, and (3) prevents otherfuture decisions. People who have trouble making decisions are sometimes trapped by the constraining nature of decision making.Every decision you make precludes other decisions, and therefore might be said to cause a loss of freedom. If you decide to marryTerry, you no longer can decide to marry Shawn. However, just as making a decision causes a loss of freedom, it also creates newfreedom, new choices and new possibilities. So making a decision is liberating as well as constraining. And a decision left unmadewill often result in a decision by default or a decision being made for you.It is important to realize that every decision you make affects the decision stream and the collections of alternatives available to youboth immediately and in the future. In other words, decisions have far reaching consequences.Concepts and Definitions1. Information. This is knowledge about the decision, the effects of its alternatives, the probability of each alternative, and so forth. Amajor point to make here is that while substantial information is desirable, the statement that "the more information, the better" is nottrue. Too much information can actually reduce the quality of a decision. See the discussion on The Effects of Quantity on DecisionMaking above.2. Alternatives. These are the possibilities one has to choose from. Alternatives can be identified (that is, searched for and located) oreven developed (created where they did not previously exist). Merely searching for preexisting alternatives will result in less effectivedecision making.
  7. 7. 3. Criteria. These are the characteristics or requirements that each alternative must possess to a greater or lesser extent. Usually thealternatives are rated on how well they possess each criterion. For example, alternative Toyota ranks an 8 on the criterion of economy,while alternative Buick ranks a 6 on the same criterion.4. Goals. What is it you want to accomplish? Strangely enough, many decision makers collect a bunch of alternatives (say cars to buyor people to marry) and then ask, "Which should I choose?" without thinking first of what their goals are, what overall objective theywant to achieve. Next time you find yourself asking, "What should I do? What should I choose?" ask yourself first, "What are mygoals?"A component of goal identification should be included in every instance of decision analysis.5. Value. Value refers to how desirable a particular outcome is, the value of the alternative, whether in dollars, satisfaction, or otherbenefit.6. Preferences. These reflect the philosophy and moral hierarchy of the decision maker. We could say that they are the decisionmakers "values," but that might be confusing with the other use of the word, above. If we could use that word here, we would say thatpersonal values dictate preferences. Some people prefer excitement to calmness, certainty to risk, efficiency to esthetics, quality toquantity, and so on. Thus, when one person chooses to ride the wildest roller coaster in the park and another chooses a mild ride, bothmay be making good decisions, if based on their individual preferences.7. Decision Quality. This is a rating of whether a decision is good or bad. A good decision is a logical one based on the availableinformation and reflecting the preferences of the decision maker.The important concept to grasp here is that the quality of a decision is not related to its outcome: a good decision can have either agood or a bad outcome. Similarly, a bad decision (one not based on adequate information or not reflecting the decision makerspreferences) can still have a good outcome.For example, if you do extensive analysis and carefully decide on a certain investment based on what you know about its risks andyour preferences, then your decision is a good one, even though you may lose money on the investment. Similarly, if you throw a dartat a listing of stocks and buy the one the dart hits, your decision is a bad one, even though the stock may go up in value.Good decisions that result in bad outcomes should thus not be cause for guilt or recrimination. If you decide to take the scenic routebased on what you know of the road (reasonably safe, not heavily traveled) and your preferences (minimal risk, prefer scenery over
  8. 8. early arrival), then your decision is a good one, even though you might happen to get in an accident, or have a flat tire in the middle ofnowhere. It is not justified to say, "Well, this was a bad decision."In judging the quality of a decision, in addition to the concerns of logic, use of information and alternatives, three other considerationscome into play:A. The decision must meet the stated objectives most thoroughly and completely. How well does the alternative chosen meet the goalsidentified?B. The decision must meet the stated objectives most efficiently, with concern over cost, energy, side effects. Are there negativeconsequences to the alternative that make that choice less desirable? We sometimes overlook this consideration in our search forthrills.C. The decision must take into account valuable byproducts or indirect advantages. A new employee candidate may also have extraabilities not directly related to the job but valuable to the company nonetheless. These should be taken into account.8. Acceptance. Those who must implement the decision or who will be affected by it must accept it both intellectually andemotionally.Acceptance is a critical factor because it occasionally conflicts with one of the quality criteria. In such cases, the best thing to do maybe to choose a lesser quality solution that has greater acceptance.For example, when cake mixes first were put on the market, manufacturers put everything into the mix--the highest quality and mostefficient solution. Only water had to be added. However, the mixes didnt sell well--they werent accepted. After investigation, themakers discovered that women didnt like the mixes because using the mixes made them feel guilty: they werent good wives becausethey were taking a shortcut to making a cake. The solution was to take the egg and sometimes the milk out of the mix so that thewomen would have something to do to "make" the cake other than just adding water. Now they had to add egg and perhaps milk,making them feel more useful. The need to feel useful and a contributor is one of the most basic of human needs. Thus, while the newsolution was less efficient in theoretical terms, it was much more acceptable. Cake mixes with the new formula became quite popular.Thus, the inferior method may produce greater results if the inferior one has greater support. One of the most important considerationsin decision making, then, is the people factor. Always consider a decision in light of the people implementation.
  9. 9. A decision that may be technologically brilliant but that is sociologically stupid will not work. Only decisions that are implemented,and implemented with thoroughness (and preferably enthusiasm) will work the way they are intended to.Approaches to Decision MakingThere are two major approaches to decision making in an organization, the authoritarian method in which an executive figure makes adecision for the group and the group method in which the group decides what to do.1. Authoritarian. The manager makes the decision based on the knowledge he can gather. He then must explain the decision to thegroup and gain their acceptance of it. In some studies, the time breakdown for a typical operating decision is something like this:make decision, 5 min.; explain decision, 30 min.; gain acceptance, 30 min.2. Group. The group shares ideas and analyses, and agrees upon a decision to implement. Studies show that the group often hasvalues, feelings, and reactions quite different from those the manager supposes they have. No one knows the group and its tastes andpreferences as well as the group itself. And, interestingly, the time breakdown is something like this:group makes decision, 30 min.; explain decision, 0 min.; gain acceptance, 0 min.Clearly, just from an efficiency standpoint, group decision making is better. More than this, it has been shown many times that peopleprefer to implement the ideas they themselves think of. They will work harder and more energetically to implement their own idea thanthey would to implement an idea imposed on them by others. We all have a love for our own ideas and solutions, and we will alwayswork harder on a solution supported by our own vision and our own ego than we will on a solution we have little creative involvementwith.There are two types of group decision making sessions. First is free discussion in which the problem is simply put on the table for thegroup to talk about. For example, Joe has been offered a job change from shift supervisor to maintenance foreman. Should he take thejob?The other kind of group decision making is developmental discussion or structured discussion. Here the problem is broken down intosteps, smaller parts with specific goals. For example, instead of asking generally whether Joe should take the job, the group works onsub questions: What are Joes skills? What skills does the new job require? How does Joe rate on each of the skills required? Noticethat these questions seek specific information rather than more general impressionistic opinions.
  10. 10. Developmental discussion (1) insures systematic coverage of a topic and (2) insures that all members of the group are talking aboutthe same aspect of the problem at the same time.Some Decision Making StrategiesAs you know, there are often many solutions to a given problem, and the decision makers task is to choose one of them. The task ofchoosing can be as simple or as complex as the importance of the decision warrants, and the number and quality of alternatives canalso be adjusted according to importance, time, resources and so on. There are several strategies used for choosing. Among them arethe following:1. Optimizing. This is the strategy of choosing the best possible solution to the problem, discovering as many alternatives as possibleand choosing the very best. How thoroughly optimizing can be done is dependent onA. importance of the problemB. time available for solving itC. cost involved with alternative solutionsD. availability of resources, knowledgeE. personal psychology, valuesNote that the collection of complete information and the consideration of all alternatives is seldom possible for most major decisions,so that limitations must be placed on alternatives.2. Satisficing. In this strategy, the first satisfactory alternative is chosen rather than the best alternative. If you are very hungry, youmight choose to stop at the first decent looking restaurant in the next town rather than attempting to choose the best restaurant fromamong all (the optimizing strategy). The word satisficing was coined by combining satisfactory and sufficient. For many smalldecisions, such as where to park, what to drink, which pen to use, which tie to wear, and so on, the satisficing strategy is perfect.3. Maximax. This stands for "maximize the maximums." This strategy focuses on evaluating and then choosing the alternatives basedon their maximum possible payoff. This is sometimes described as the strategy of the optimist, because favorable outcomes and highpotentials are the areas of concern. It is a good strategy for use when risk taking is most acceptable, when the go-for-broke philosophyis reigning freely.
  11. 11. 4. Maximin. This stands for "maximize the minimums." In this strategy, that of the pessimist, the worst possible outcome of eachdecision is considered and the decision with the highest minimum is chosen. The Maximin orientation is good when the consequencesof a failed decision are particularly harmful or undesirable. Maximin concentrates on the salvage value of a decision, or of theguaranteed return of the decision. Its the philosophy behind the saying, "A bird in the hand is worth two in the bush."Quiz shows exploit the uncertainty many people feel when they are not quite sure whether to go with a maximax strategy or amaximin one: "Okay, Mrs. Freen, you can now choose to take what youve already won and go home, or risk losing it all and find outwhats behind door number three."Example: I could put my $10,000 in a genetic engineering company, and if it creates and patents a new bacteria that helps plantsresist frost, I could make $50,000. But I could also lose the whole $10,000. But if I invest in a soap company, I might make only$20,000, but if the company goes completely broke and gets liquidated, Ill still get back $7,000 of my investment, based on its bookvalue.Example: Its fourth down and ten yards to go on your twenty yard line. Do you go for a long pass or punt? Maximax would be topass; Maximin would be to punt.Decision Making ProcedureAs you read this procedure, remember our discussion earlier about the recursive nature of decision making. In a typical decisionmaking situation, as you move from step to step here, you will probably find yourself moving back and forth also.1. Identify the decision to be made together with the goals it should achieve. Determine the scope and limitations of the decision.Is the new job to be permanent or temporary or is that not yet known (thus requiring another decision later)? Is the new package forthe product to be put into all markets or just into a test market? How might the scope of the decision be changed--that is, what are itspossible parameters?When thinking about the decision, be sure to include a clarification of goals: We must decide whom to hire for our new secretary, onewho will be able to create an efficient and organized office. Or, We must decide where to go on vacation, where we can relax and getsome rest from the fast pace of society.2. Get the facts. But remember that you cannot get all the facts. Get as many facts as possible about a decision within the limits oftime imposed on you and your ability to process them, but remember that virtually every decision must be made in partial ignorance.
  12. 12. Lack of complete information must not be allowed to paralyze your decision. A decision based on partial knowledge is usually betterthan not making the decision when a decision is really needed. The proverb that "any decision is better than no decision," whileperhaps extreme, shows the importance of choosing. When you are racing toward a bridge support, you must decide to turn away tothe right or to the left. Which way you turn is less important than the fact that you do indeed turn.As part of your collection of facts, list your feelings, hunches, and intuitive urges. Many decisions must ultimately rely on or beinfluenced by intuition because of the remaining degree of uncertainty involved in the situation.Also as part of your collection of facts, consult those who will be affected by and who will have to implement your decision. Inputfrom these people not only helps supply you with information and help in making the decision but it begins to produce the acceptancenecessary in the implementers because they feel that they are part of the decision making process. As Russell Ackoff noted in The Artof Problem Solving, not consulting people involved in a decision is often perceived as an act of aggression.3. Develop alternatives. Make a list of all the possible choices you have, including the choice of doing nothing. Not choosing one ofthe candidates or one of the building sites is in itself a decision. Often a non decision is harmful as we mentioned above--not choosingto turn either right or left is to choose to drive into the bridge. But sometimes the decision to do nothing is useful or at least better thanthe alternatives, so it should always be consciously included in the decision making process.Also be sure to think about not just identifying available alternatives but creating alternatives that dont yet exist. For example, if youwant to choose which major to pursue in college, think not only of the available ones in the catalog, but of designing your own courseof study.4. Rate each alternative. This is the evaluation of the value of each alternative. Consider the negative of each alternative (cost,consequences, problems created, time needed, etc.) and the positive of each (money saved, time saved, added creativity or happinessto company or employees, etc.). Remember here that the alternative that you might like best or that would in the best of all possibleworlds be an obvious choice will, however, not be functional in the real world because of too much cost, time, or lack of acceptanceby others.Also dont forget to include indirect factors in the rating. If you are deciding between machines X, Y, and Z and you already have anemployee who knows how to operate machine Z, that fact should be considered. If you are choosing an investigative team to send toJapan to look at plant sites and you have very qualified candidates A, B, and C, the fact that B is a very fast typist, a superiorphotographer or has some other side benefit in addition to being a qualified team member, should be considered. In fact, what you put
  13. 13. on your hobbies and interests line on your resume can be quite important when you apply for a job just because employers areinterested in getting people with a good collection of additional abilities.5. Rate the risk of each alternative. In problem solving, you hunt around for a solution that best solves a particular problem, and bysuch a hunt you are pretty sure that the solution will work. In decision making, however, there is always some degree of uncertainty inany choice. Will Bill really work out as the new supervisor? If we decide to expand into Canada, will our sales and profits reallyincrease? If we let Jane date Fred at age fifteen, will the experience be good? If you decide to marry person X or buy car Y or go toschool Z, will that be the best or at least a successful choice?Risks can be rated as percentages, ratios, rankings, grades or in any other form that allows them to be compared. See the section onrisk evaluation for more details on risking.6. Make the decision. If you are making an individual decision, apply your preferences (which may take into account the preferencesof others). Choose the path to follow, whether it includes one of the alternatives, more than one of them (a multiple decision) or thedecision to choose none.And of course, dont forget to implement the decision and then evaluate the implementation, just as you would in a problem solvingexperience.One important item often overlooked in implementation is that when explaining the decision to those involved in carrying it out orthose who will be affected by it, dont just list the projected benefits: frankly explain the risks and the drawbacks involved and tell whyyou believe the proposed benefits outweigh the negatives. Implementers are much more willing to support decisions when they (1)understand the risks and (2) believe that they are being treated with honesty and like adults.Remember also that very few decisions are irrevocable. Dont cancel a decision prematurely because many new plans require time towork--it may take years for your new branch office in Paris to get profitable--but dont hesitate to change directions if a particulardecision clearly is not working out or is being somehow harmful. You can always make another decision to do something else. For a great book about decision making, visit
  14. 14. Because making decisions involves a degree of risk, it would be helpful to examine risk and risk analysis in this chapter in order togain an understanding of what is involved. Risk and uncertainty create anxiety, yet they are necessary components of an active life.General Comments on Risk Taking1. Only the risk takers are truly free. All decisions of consequence involve risk. Without taking risks, you cannot grow or improveor even live.2. There is really no such thing as permanent security in anything on earth. Not taking risks is really not more secure than takingthem, for your present state can always be changed without action on your part. If you dont take the risk of dying by driving to thestore, your house could collapse on you and kill you anyway.3. You are supposed to be afraid when you risk. Admit your fears--of loss, of rejection, of failure.4. Risking normally involves a degree of separation anxiety--the anxiety you feel whenever you are removed from something thatmakes you feel secure. Many children feel this when they first leave their parents for school. Some college students feel this whenthey go off to college. Travelers sometimes feel it when they get homesick. The way to overcome separation anxiety is to build abridge between the familiar and secure and the new. Find out what the new place--school or country--is like and how its elementscompare to familiar and secure things at home. Take familiar things with you--books, teddy bear, popcorn popper, whatever.The same is true of all risks. Make the opportunity as familiar as possible and learn as much about it as you can before you release thesecurity of the old. Find out about the new job, its location, the lifestyle of those who live there, and so on.The Orthodox Theory of Risk EvaluationThe traditional strategy for evaluating risks is to use an expected value calculation, based on the simple idea that the expected value ofa risk is the value of the possible outcome discounted by the probability of its realization. The formula is EV=PR or expected valueequals prize times risk (or chance). Thus, if you have one chance in a million of winning a million dollars, your expected value is onedollar (which is one millionth of a million dollars). Expected value calculations are often used when comparing an amount of moneyto be invested with the probable payoff. (Note: if the risk is, for example, one in twenty, you can divide the prize by twenty, which isthe same as multiplying the prize by one twentieth.)
  15. 15. Lets take a typical state lottery, for example. The investment for a ticket is a dollar. The usual prize is about $6,500,000 and thechance of winning is about one in 14,800,000. By discounting the possible outcome by the chance of winning (dividing $6.5 millionby 14.8 million), we discover that the expected value of the lottery ticket is about 43.9 cents. Since a ticket costs $1.00 (more thantwice as much as its expected value), we would conclude that this is a poor risk. Only when the expected value meets or exceeds therequired expense is the risk considered worth taking, according to this theory.______________________________________________________________________Try It YourselfExpected Value. Calculate the expected value of each of the following risks. Divide the prize by the chance, and compared theanswer with the cost of the ticket to decide whether the risk is worth taking.1. Irish Sweepstakes. Ticket: $2.50 Prize: $100,000,000 Chance: 1 in 60,000,0002. State Lottery. Ticket: $1.00 Prize: $42,300,000 Chance: 1 in 14,800,000 (Note: Calculate the expected value for just a singlewinner and for the number of winners youd expect based on 80,000,000 entries.)3. Readers Digest Sweepstakes. Ticket: 32 cent stamp to return the entry Prize: $6,000,000 Chance: 1 in 256,000,0004. Publishers Clearinghouse Sweepstakes. Ticket: 32 cent stamp to return the entry Prize: $10,000,000 Chance: 1 in 140,000,0005. Charity Raffle. Ticket: $5.00 Prize: $12,400 (new car) Chance: 1 in 3,0006. Vegas Roulette #1. Ticket: $20 bet Prize: $380 Chance: 1 in 357. Reno Roulette #2 Ticket: $25 bet Prize: $975 Chance: 1 in 358. Pearl in Oyster Ticket: $10 Prize: $50 Chance: 1 in 89. Extended Warranty Ticket (Price of Extended Warranty): $45 Prize (Cost of average covered warranty repair): $180 Chance: 1 in1210. In Your Dreams Ticket: $1.00 Prize: $500,000 Chance: 1 in 250______________________________________________________________________Many risks have multiple possible outcomes, each outcome with its own probability of occurrence and its own value. The expectedvalue of a given decision in such cases is the sum of all the values of each outcome, each diminished by its individual probability. Theformula isEV = sumn (pn x rn)
  16. 16. where p is the probability and r is the reward or value of the risk. Note in the following examples that the value of an outcome isrepresented numerically, but it does not need to represent dollars, or even physical units. A 10 could be units of happiness, pleasure,pain, embarrassment, and so forth, as well as dollars.Example: Should I go scuba diving this weekend? If I do, there is a ninety percent probability that I will have a lot of fun. I quantifythis great fun as 10 fun points. There is also a ten percent probability that I will get hurt, which I quantify as minus 20 fun points. If Imake the other decision, to stay home, there is a ninety-nine percent probability that I will be bored, represented by a minus 2 funpoints, and a one percent probability that something exciting will happen, which I represent as five fun points (half as exciting asgoing scuba diving). Our expected value worksheet looks like this:Probability Reward_____ .9 x +10 = +9||_____ .1 x -20 = -2Y|_Scuba?_| Total = 7N||_____ .99 x -2 = -1.98||_____ .01 x +5 = + .05Total = -1.93Here we see that the expected value of going diving is 7, which is much higher than the expected value of staying home, which is anegative 1.93.As another example, suppose Im trying to decide whether or not to attempt a repair on my computer or whether to have a dealer fix it.If I attempt the repair, there are three possible outcomes. One is that Ill succeed, which I value both financially, experientially, andegotistically, so I give that a +10. Second is that I will increase the cost of repairing the computer by damaging something. This I rateat -8. The third possibility is that I will ruin the computer and be totally humiliated. This I rate at -20. The probability I see for each ofthese possibilities is, in order, 50%, 30%, and 20%. Do note that for any given decision, the probabilities of all possible outcomesmust add up to 100%.On the other hand, if I have a dealer repair the computer, there are two possibilities. One is that it will cost a modest amount ofmoney, which I rate at a -2, since I will be out a few bucks and will have to haul the computer into the shop and back. The other
  17. 17. possibility is that the repair will cost major money, which I rate at a -9. The probabilities for each of these I predict at 20% for acheap repair and 80% for an expensive one. Our EV worksheet would then look like this:Probability Reward_____ .5 x +10 = +5||_____ .3 x -8 = -2.4||_____ .2 x -20 = -4Y|Me Fix?_| Total -1.4N||_____ .8 x -9 = -7.2||_____ .2 x -2 = -0.4Total -7.6Here we see that both expected values are negative, meaning that this decision will probably result in discomfort either way.However, the expected value for doing the repair is "higher" (less negative) than that for having the dealer do it, so that is the way ourcalculations tell us to go. Note, of course, that if we decide our probabilities are different, or if we decide that our rewards aredifferent, the expected values will change.______________________________________________________________________Try It YourselfExpected Value. Work out each of these for expected value and determine which decision is best. Partial answers at the end.1. You want to decide whether or not to take the freeway home from an event youve attended. From experience, you calculate that ifyou take the freeway, you will either speed home, which you rate at a +8 on the happiness scale, or you will get into a traffic jam,which you rate at a -6 on the happiness scale. If you take the side streets, you will either get home okay, which is a +4 on thehappiness scale (since its only half as fast as the freeway) or you will hit another traffic jam, which you rate as a -7, slightly worsethan a jam on the freeway. The probability of a freeway jam is 60% (youll have to figure out the probability for speeding home). Theprobability for getting home okay on the side streets is 30%.
  18. 18. 2. Your crop of cotton is infested with insects and you want to decide which pesticide to use. Some of the insects are probablyresistant to the different available pesticides, so you sit down and figure out the following probabilities. If you use ToxiBug, there is a22% probability that it will kill 95% of the bugs on your crops. There is a 49% probability that it will kill only 71% of the bugs, and a29% probability that it will kill only 43% of the bugs. (Use the bug percentages as reward numbers, so that 95% is a reward of 95.)If you use Bug-O-Kill, there is a 71% probability that it will kill 90% of the bugs, a 24% probability that it will kill 11% of the bugs,and a 5% probability that it will kill 19% of the bugs.If you use MegaDeath Bug Viability Terminator, there is a 90% chance that 60% of the bugs will be killed, and a 10% chance that 5%will be killed.3. You have been retained by Amalgamated Pencil Sharpeners, Inc. to help determine whether the company should export its newsharpener model XT-S to Brazil. If APS does export, there are three foreseen possibilities. First, there is a 25% probability that theproduct will sell well, earning the company (after startup costs) $280,000. Second, there is a 40% probability that the sharpeners willhave only modest performance, earning the company a net of only $15,000. Lastly, the product might be rejected, causing thecompany to lose its startup costs of $175,000. The probability for this is 35%.If the company decides not to export the sharpeners, it could invest the startup money with a 90% probability of making a net of$18,000 and a 10% probability of losing a net of $27,000.What should the company do?4. As a diving buff, you have been asked to help salvage a sunken treasure ship off the coast of Florida. Your only problem is anabundance of riches: There are three ships to choose from. And, to make life interesting, there is a little uncertainty about whethereach has already been salvaged. (If the ship has already been salvaged, there will be no treasure at all left, and the attempt will result ina net loss equal to the cost of mounting the expedition.) Judging by the records of each ships inventory and the probability of previoussalvaging, you have this information:If you salvage the Jacques DAmbois, there is a 60% probability of finding the $20,000,000 in gold and silver bars on board. Cost ofsalvaging this wreck is $5,000,000.If you salvage the Acana, there is a 75% probability of finding $11,000,000 in doubloons and jewels. Cost of salvaging this wreck is$3,000,000.If you salvage the Princess Avanti, there is a 20% probability of finding $30,000,000 in gold and a 25% probability of finding only$15,000,000. Cost of salvaging this wreck is $4,000,000.
  19. 19. Hint: Subtract the cost of salvaging from the hoped for return in each case. Subtract the probability of success from 100% to find theprobability of failure. Failure results in the expense of salvaging (a net loss).Which ship should be salvaged?5. Penelope has a serious illness for which doctors have recommended surgery. If she has the operation, there is a 60% chance she willrecover and live another 50 years. There is a 20% chance she will live only 20 more years. And there is a 20% percent chance that shewill die on the operating table or shortly thereafter. If she does not have the operation, there is a 60% chance that she will live onlyfive years. There is a 15% percent chance that she will live 15 years. And there is a 25% chance that she will spontaneously recoverand live 50 years. For each case, let the number of years to live equal the possible reward. For the possibility of dying on the operatingtable, make that equal to a negative of the expected value of not having the operation at all (so calculate the not having the operationEV first).Should she have the operation?6. You have $250,000 to invest for a year. If you put it in stocks, there is a 50 percent chance that you will net a return of $40,000.There is, however a 20 percent chance that youll lose $2,000 and a 30 percent chance that the market will really decline and youlllose $50,000.If you put the money in the bank, there is a 95 percent chance that youll earn $17,500 in interest. There is, however, just a smallchance--5 percent--that the bank will go broke, and since the FDIC insurance covers only $100,000, you would lose $150,000.Which investment has the highest expected value?7. You are trying to decide between three used cars, all of which are priced the same. If you buy used car number one, there is a 70percent probability that youll have to spend $400 to get the engine back in shape. However, there is a 30 percent probability that theengine will have to be replaced, which will cost you $2,000.If you choose car number 2, there is a 50 percent probability that you wont have to spend any money at all, a 30 percent probabilitythat emission repairs will cost only $200, but there is a 20 percent chance that the car will require a California smog conversion (sinceit may be a European import that hasnt been built for California). This will cost you $5000.If you choose car number three, you will face a 60 percent probability of an $800 transmission repair, a 35 percent probability of asmall transmission adjustment, and a 5 percent possibility that youll need to spend $1600 to fix the engine and the transmission.Which car should you buy? Consider the costs as negative values and choose the one with the lowest negative total.
  20. 20. 8. Your true love comes up to you and says, "Darling, I cant decide whether we should go to the beach or to a movie, because whilethe beach would be twice as much fun if it doesnt rain, there is a 30 percent chance of rain today. And if it rains, the beach would beno fun at all." You smile knowingly and reply, "Well, sweetheart, I just happen to know how to calculate expected values. Ill solve theproblem for us." If the fun you would have at the beach is a 10, what should you decision be?______________________________________________________________________Advice on Risking1. Decide whether the risk is necessary or desirable. Spend some careful thought before acting, so that you will not end up takingunnecessary risks.2. Risk for the right reasons and when you are calm and thoughtful. Dont take a risk because you are angry, hurt, depressed,desperate, or frightened. Dont take risks just to get revenge or to harm someone else. Dont risk when you are incapable of rationalthought.3. Have a goal. When you take a risk, have a clear purpose in mind so that you will know, after the fact, whether you succeeded ornot. What will taking the risk accomplish?4. Determine the possible loss as well as the gain. That is, know exactly what the consequences of failure will be. Unless you knowpretty accurately what both loss and gain will be, you do not understand the risk. There is a tendency either to underestimate or tooverestimate the consequences of risk. Underestimation can result in surprising damage, cost, setbacks, pain, whatever. Butoverestimation is just as problematic, because it can keep us from taking the risks we should be taking. Many times, upon reflection,the worst case event of a failed risk is much less harmful or negative that we originally believed.Its a good idea in fact to list all the good expected effects of a successful outcome and all the bad expected effects of an unsuccessfuloutcome.5. Try to make an accurate estimate about the probability of each case. Is the probability of success one in two, one in ten, one ina hundred, one in a million? This can be sometimes difficult to do, but usually you can guess the probability within an order ofmagnitude.6. When possible, take one risk at a time. Divide your actions or goals wherever possible so that you are not combining risks unlessabsolutely necessary. Simultaneous risking increases anxiety, creates confusion, and makes failure analysis very difficult.7. Use imaging or role playing to work through the various possibilities, successes and failures, so that you will be mentally preparedfor any outcome. Think about what can go right and what can go wrong and how you will respond to or adjust to each possibility.8. Use a plan. Set up a timetable with a list of steps to take. Use the plan as a guideline, but be flexible.9. Act decisively. When you have evaluated the risk and decided that its worth it, act. Go for it. Dont hesitate at the threshold orhalfway through. Once you get going, be courageous. Grit your teeth and move forward. Dont procrastinate and dont act half
  21. 21. heartedly.10. Dont expect complete success. You may get it, of course, but chances are the result of your risk will not be exactly what you hadimagined and there will be more a degree of success than absolute success or failure.Risk Management StrategiesIn order of precedence, the strategies are:1. Dismiss extremely remote or unrealistic possibilities. For example, in the decision, Shall I go to the store? there are risks likedying on the freeway, being shot by robbers, buying poisoned food, and so forth, but these should not normally enter into the riskevaluation because they are highly if not extremely improbable. Remember that all life is accompanied by risk. Ten thousandtelevision sets catch fire each year, a hundred thousand people walk through plate glass each year, 125,000 do-it-yourselfers injurethemselves with power tools each year, 70,000 children are injured by toys each year, ten thousand people are poisoned by aspirineach year. But what are we willing to give up? Some of these are not really remote, but we are willing to take the risk. E.g. automobiledeaths. 1 chance in 4000 each year of dying.And of course whenever you trust someone, you risk betrayal; when you open yourself, you risk exploitation or ridicule; wheneveryou hand over a dollar, you risk being defrauded.2. Insofar as possible, avoid catastrophes. If there is a small but significant chance for catastrophe, then the regular expected valuecalculations may not apply.A major principle of risk management is to avoid any real risk of catastrophe at any reasonable cost. The difficulty of applying thisprinciple comes from the uncertainty of what is a real risk and what is a reasonable cost.3. Recognize the tradeoffs. Remember that every action of life has some risk to it. Even when we dont take the risk upon ourselves,risk is often put upon us by the nature of life and society. Eating you risk food poisoning or choking, but you have to eat or youll die.Socializing you risk disease, driving or flying you risk crashing, but in some sense you have to socialize and travel. Lying in the sunyou risk skin cancer; smoking you risk lung cancer; eating French fries you risk heart disease.Dont deny the risks involved in living and dont worry excessively about the consequences of modern life.
  22. 22. 4. Maximize Expected Values. Normally, the expected value of each alternative shows its relative preferability. That is, you areopting for the greatest probability of the greatest good. Remember, though, that these calculations are guides, and are based on whatmay be very subjective probabilities and rewards. You are not "required by law" to choose any particular alternative. If you believethat the alternative with the highest EV is a poor choice, you should reconsider the probabilities and rewards you have assigned to allthe alternatives.With these ideas in mind, youll better understand why some people pursue dangerous sports like skiing, sky diving, race car drivingand so forth. The risk/benefit ratio is acceptable to them. It may be useful to note here, too, that most people are not rational risktakers. They take some risks all out of proportion to any expected return and avoid other risks that have a large expected valuecompared to the risk.Answers to Expected Value Questions:1. The freeway at -.4 is less negative than side roads.2. Toxibug at 68.16.3. Export at 14.75.4. Jacques DAmbois at 7.5. Operate at 30.45.6. Put it in the bank at 9.125.7. Car #3 at $595.8. Go to the beach at 7.