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Decision Models
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6.1 Introduction to Decision Analysis
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6.1 Introduction to Decision Analysis
• Maximizing expected profit is a common
criterion when probabilities can be
assessed.
• Payoff Tables
– Payoff table analysis can be applied when:
• There is a finite set of discrete decision alternatives.
• The outcome of a decision is a function of a single future event.
– In a Payoff table -
• The rows correspond to the possible decision alternatives.
• The columns correspond to the possible future events.
• Events (states of nature) are mutually exclusive and collectively
exhaustive.
• The table entries are the payoffs.
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TOM BROWN INVESTMENT DECISION
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TOM BROWN
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TOM BROWN - Solution
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The Payoff Table
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Decision Making Under Uncertainty -
The Maximin Criterion
• This criterion is based on the worst-case scenario.
– It fits both a pessimistic and a conservative decision
maker’s styles.
– A pessimistic decision maker believes that the worst
possible result will always occur.
– A conservative decision maker wishes to ensure a
guaranteed minimum possible payoff.
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TOM BROWN - The Maximin Criterion
=MAX(H4:H7)
=MIN(B4:F4)
Drag to H7
* FALSE is the range lookup argument in
the VLOOKUP function in cell B11 since the =VLOOKUP(MAX(H4:H7),H4:I7,2,FALSE
values in column H are not in ascending )
order
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The Maximin Criterion - spreadsheet
I4
Cell I4 (hidden)=A4
Drag to I7
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Decision Making Under Uncertainty -
The Minimax Regret Criterion
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Decision Making Under Uncertainty -
The Minimax Regret Criterion
• The Minimax Regret Criterion
– To find an optimal decision, for each state of nature:
• Determine the best payoff over all decisions.
• Calculate the regret for each decision alternative as the
difference between its payoff value and this best payoff
value.
– For each decision find the maximum regret over all
states of nature.
– Select the decision alternative that has the minimum of
these “maximum regrets.”
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TOM BROWN – Regret Table
The
ThePayoff
PayoffTable
Table
Decision
Decision Large
Largerise
rise Small
Smallrise
rise No
Nochange
changeSmall
Smallfall
fall Large
Largefall
fall
Gold
Gold -100
-100 100
100
Investing in200
200 300
300 no 00
Stock generates
Bond
Bond 250
250 200
200 when
regret 150
150 -100
the market exhibits-150
-100 -150
Stock
Stock 500
500 250
250 a100
large rise-200
100 -200 -600
-600
C/D
C/D 60
60 60
60 60
60 60
60 60
60
=MAX(B14:F14)
Drag to H18
=MAX(B$4:B$7)-B4
Drag to F16
=MIN(H13:H16)
=VLOOKUP(MIN(H13:H16),H13:I16,2,FALSE) 23
Decision Making Under Uncertainty -
The Maximax Criterion
• This criterion is based on the best possible scenario.
It fits both an optimistic and an aggressive decision maker.
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Decision Making Under Uncertainty -
The Maximax Criterion
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TOM BROWN - The Maximax Criterion
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Decision Making Under Uncertainty -
The Principle of Insufficient Reason
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TOM BROWN - Insufficient Reason
• Sum of Payoffs
– Gold 600 Dollars
– Bond 350 Dollars
– Stock 50 Dollars
– C/D 300 Dollars
• Based on this criterion the optimal decision
alternative is to invest in gold.
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Decision Making Under Uncertainty –
Spreadsheet template
Payoff Table
RESULTS
Criteria Decision Payoff
Maximin C/D Account 60
Minimax Regret Bond 400
Maximax Stock 500
Insufficient Reason Gold 100
EV Bond 130
EVPI 141 29
Decision Making Under Risk
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Decision Making Under Risk –
The Expected Value Criterion
• For each decision calculate the expected payoff
as follows:
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TOM BROWN - The Expected Value Criterion
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When to use the expected value
approach
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The Expected Value Criterion -
spreadsheet Cell H4 (hidden) = A4
Drag to H7
=SUMPRODUCT(B4:F4,$B$8:$F$8
)
=MAX(G4:G7) Drag to G7
=VLOOKUP(MAX(G4:G7),G4:H7,2,FALSE)
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6.4 Expected Value of Perfect Information
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TOM BROWN - EVPI
If it were known with certainty that there will be a “Large Rise” in the market
The-100
Expected Value of Perfect Information
Decision Large rise
Large rise Small rise No change Small fall Large fall
Gold 250
-100 100 200 300 0
Bond 250 200 150 -100 -150
Stock
Stock 500500 250 100 -200 -600
C/D 60 60 60 60 60
Probab. 600.2 0.3 0.3 0.1 0.1
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TOM BROWN - EVPI
The-100
Expected Value of Perfect Information
Decision Large rise Small rise No change Small fall Large fall
Gold 250
-100 100 200 300 0
Bond 250 200 150 -100 -150
Stock 500
500 250 100 -200 -600
C/D 60 60 60 60 60
Probab. 600.2 0.3 0.3 0.1 0.1
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Posterior (revised) Probabilities
spreadsheet template
Bayesian Analysis
Indicator 1 Indicator 2
States Prior Conditional Joint Posterior States Prior Conditional Joint Posterior
of Nature Probabilities Probabilities Probabilities Probabilites of Nature Probabilities Probabilities Probabilities Probabilites
Large Rise 0.2 0.8 0.16 0.286 Large Rise 0.2 0.2 0.04 0.091
Small Rise 0.3 0.7 0.21 0.375 Small Rise 0.3 0.3 0.09 0.205
No Change 0.3 0.5 0.15 0.268 No Change 0.3 0.5 0.15 0.341
Small Fall 0.1 0.4 0.04 0.071 Small Fall 0.1 0.6 0.06 0.136
Large Fall 0.1 0 0 0.000 Large Fall 0.1 1 0.1 0.227
s6 0 0 0.000 s6 0 0 0.000
s7 0 0 0.000 s7 0 0 0.000
s8 0 0 0.000 s8 0 0 0.000
P(Indicator 1) 0.56 P(Indicator 2) 0.44
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Expected Value of Sample Information
EVSI
• This is the expected gain from making decisions
based on Sample Information.
• Revise the expected return for each decision using
the posterior probabilities as follows:
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TOM BROWN – Conditional Expected Values
The revised probabilities payoff table
Decision Large rise Small rise No change Small fall Large fall
Gold -100 100 200 300 0
Bond 250 200 150 -100 -150
Stock 500 250 100 -200 -600
C/D 60 60 60 60 60
P(State|Positive) 0.286 0.375 0.268 0.071 0
P(State|negative) 0.091 0.205 0.341 0.136 0.227
GOLD|“Positive” forecast) =
EV(Invest in…….
=.286(-100)+.375(100 )+.268( 200)+.071( 300)+0( 0 ) = $84
GOLD | “Negative” forecast) =
EV(Invest in …….
=.091(-100 )+.205( 100 )+.341( 200 )+.136( 300 )+.227( 0 ) = $120
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TOM BROWN – Conditional Expected Values
51
Expected Value of Sampling
Information (EVSI)
• The expected gain from buying the forecast is:
EVSI = ERSI – EREV = 192.5 – 130 = $62.5
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TOM BROWN – Solution
EVSI spreadsheet template
Payoff Table
Large Rise Small Rise No Change Small Fall Large Fall s6 s7 s8 EV(prior) EV(ind. 1) EV(ind. 2)
Gold -100 100 200 300 0 100 83.93 120.45
Bond 250 200 150 -100 -150 130 179.46 67.05
Stock 500 250 100 -200 -600 125 249.11 -32.95
C/D Account 60 60 60 60 60 60 60.00 60.00
d5
d6
d7
d8
Prior Prob. 0.2 0.3 0.3 0.1 0.1
Ind. 1 Prob. 0.286 0.375 0.268 0.071 0.000 #### ### ## 0.56
Ind 2. Prob. 0.091 0.205 0.341 0.136 0.227 #### ### ## 0.44
Ind. 3 Prob.
Ind 4 Prob.
RESULTS
Prior Ind. 1 Ind. 2 Ind. 3 Ind. 4
optimal payoff 130.00 249.11 120.45 0.00 0.00
optimal decision Bond Stock Gold
EVSI = 62.5
EVPI = 141
Efficiency= 0.44
53
6.6 Decision Trees
54
Characteristics of a decision tree
• A Decision Tree is a chronological representation of the
decision process.
• The tree is composed of nodes and branches.
Chance A branch emanating from a
node decision node corresponds to a
P(S2)
Decision decision alternative. It includes a
node cost or benefit value.
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BILL GALLEN - Solution
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BILL GALLEN - The Decision Tree 0
3
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BILL GALLEN - The Decision Tree
Buy land and -300000 – 30000 – 500000 + 950000 = 120,000
apply for variance Build Sell
-500,000 950,000
?
-75,000
Sell
? 260,000
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BILL GALLEN - The Decision Tree
115,000
Build Sell
-500,000 950,000
?
-75,000
Sell
? 260,000
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BILL GALLEN - The Decision Tree
115,000
Build Sell
-500,000 950,000
?
-75,000
Sell
? 260,000
65
BILL GALLEN - The Decision Tree
115,000
Build Sell
23 -500,000 24 950,000
25
22
?
.7
-75,000
Sell
?
.3 26 27
260,000
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BILL GALLEN - The Decision Tree
Determining the Optimal Strategy
115,000 115,000 115,000
115,000 115,000 115,000
115,000
Build Sell
23 -500,000 24 950,000
25
58,000 0.70
? -75,000 -75,000 -75,000 -75,000
22 -75,000 -75,000
-75,000
Sell
0.30
? 26 27
260,000
$20,000
$58,000
Buy land; Apply
$20,000 for variance
$-5,000
Sell
land
$-75,000
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BILL GALLEN - The Decision Tree
Excel add-in: Tree Plan
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BILL GALLEN - The Decision Tree
Excel add-in: Tree Plan
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6.7 Decision Making and Utility
• Introduction
– The expected value criterion may not be appropriate
if the decision is a one-time opportunity with
substantial risks.
– Decision makers do not always choose decisions
based on the expected value criterion.
• A lottery ticket has a negative net expected return.
• Insurance policies cost more than the present value of the
expected loss the insurance company pays to cover
insured losses.
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The Utility Approach
• It is assumed that a decision maker can rank decisions in a
coherent manner.
• Utility values, U(V), reflect the decision maker’s perspective
and attitude toward risk.
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Determining Utility Values
74
Determining Utility Values
Indifference approach for assigning utility values
75
Determining Utility Values
Indifference approach for assigning utility values
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Determining Utility Values
Indifference approach for assigning utility values
1-p Rmax
Rij
Rmin
1-p Rmax
Rij
Rmin
U(100)=.7U(150)+.3U(-50) $150
$100
= .7(1) + .3(0) = .7
1-p
p -50
80
TOM BROWN - Determining Utility Values
• Data
– The highest payoff was $500. Lowest payoff was -$600.
– The indifference probabilities provided by Tom are
Payoff -600 -200 -150 -100 0 60 100 150 200 250 300 500
Prob. 0 0.25 0.3 0.36 0.5 0.6 0.65 0.7 0.75 0.85 0.9 1
81
TOM BROWN – Optimal decision (utility)
RESULTS
Criteria Decision Value
Exp. Utility Stock 0.675
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Three types of Decision Makers
• Risk Averse -Prefers a certain outcome to a chance
outcome having the same expected value.
83
The Utility Curve for a
Utility Risk Averse Decision Maker
U(200)
U(150)
EU(Game)
U(200)
U(150)
EU(Game) A risk averse decision maker avoids
the thrill of a game-of-chance,
whose expected value is EV, if he
U(100) can have EV on hand for sure.
Furthermore, a risk averse decision
maker is willing to pay a premium…
…to buy himself (herself) out of the
game-of-chance.
Payoff
86