Incorporating risk into decisions

Risk and uncertainty

All businesses face risk. However, given that most investors are risk-averse, firms should only take on board extra risk if they expect a higher return to compensate. This page looks as quantitative techniques to incorporate risk into decision making.

Defining risk

The simplest definition of risk is that it is the variability of possible returns. For example, we cannot predict future sales with certainty.

An important aspect of this definition is that the actual outcome could be better or worse than expected - sales could be higher or lower than our best guess. We can thus talk about downside risk exposure and upside potential. Note that some authors define "true risk" as only considering the downside.

Another popular definition is that risk = probability × impact

This definition emphasises an important aspect of risk management - i.e. that we need to identify and assess potential sources of risk both in terms of their potential impact on the business and how likely they are.

Finally, some authors make a distinction between risk and uncertainty:

  • Risk is where there are a number of possible outcomes and the probability of each outcome is known.

    For example, based on past experience of digging for oil in a particular area, an oil company may estimate that they have a 60% chance of finding oil and a 40% chance of not finding oil.

  • Uncertainty occurs when there are a number of possible outcomes but the probability of each outcome is not known.

    For example, the same oil company may dig for oil in a previously unexplored area. The company knows that it is possible for them to either find or not find oil, but it does not know the probabilities of each of these outcomes.

Use of research techniques to reduce uncertainty

Market research is an important means of assessing and reducing uncertainty. For example, about the likely responses of customers to new products, new advertising campaigns and price changes.

A number of research techniques are available:

  • Focus Groups
  • Desk research (secondary research).
  • Field research (primary research). This includes:
    • motivational and
    • measurement research.

Each method will be reviewed in turn.

Focus groups

Focus groups are a common market research tool involving small groups (typically eight to ten people) selected from the broader population. The group is interviewed through facilitator-led discussions in an informal environment in order to gather their opinions and reactions to a particular subject.

For example, a supermarket may use a focus group before a product launch decision is made in order to gather opinions on a new range of pizzas.

Problems with focus groups

  • Results are qualitative.
  • The small sample size means that results may not be representative.
  • Individuals may feel under pressure to agree with other members or to give a 'right' answer.
  • Their cost and logistical complexity is frequently cited as a barrier, especially for smaller companies. On-line focus groups are becoming more popular and help to address this issue.

Desk research

The information is collected from secondary sources.

  • It obtains existing data by studying published and other available sources of information. For example, press articles, published accounts, census information.
  • It can often eliminate the need for extensive field work.

Factors to consider when using desk research

  • It may not be exactly what the researcher wants and may not be totally up to date or accurate.
  • However, it is quicker and cheaper than field research.

Field research

Information is collected from primary sources by direct contact with a targeted group.

  • Although it is more expensive and time consuming than desk research the results should be more accurate, relevant and up to date.
  • There are two types of field research:
    • motivational research
    • measurement research.

Motivational research

Here, the objective is to understand factors that influence why consumers do or do not buy particular products.

Some of the more common techniques in motivational research are:

  • Depth interviewing undertaken at length by a trained person who is able to appreciate conscious and unconscious associations and motivations and their significance.
  • Group interviewing where between six and ten people are asked to consider the relevant subject (object) under trained supervision.
  • Word association testing on being given a word by the interviewer, the first word that comes into the mind of the person being tested is noted.
  • Triad testing where people are asked which out of a given three items they prefer. If the three are brands of a given type of product (or three similar types), replies may show a great deal about which features of a product most influence the buying decision.

Measurement research

The objective here is to build on the motivation research by trying to quantify the issues involved.

  • 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.
  • This sort of information can also be collected in retail environments at the point of sale, for example, through the use of loyalty cards.

It is also possible (less accurately) to assess roughly the importance of some reasons for buying or not buying a product. The main types of measurement are:

Random sampling where each person in the target population has an equal chance of being selected. Such samples are more likely to be representative, making predictions more reliable. However,the technique may be unfeasible in practice.

Quota sampling where samples are designed to be representative with respect to pre-selected criteria.

  • For example, if the target population is 55% women and 45% men, then a sample of 200 people could be structured so 110 women and 90 men are asked, rather than simply asking 200 people and leaving it up to chance whether or not the gender mix is typical.
  • The main disadvantage of quota sampling is that samples may still be biased for non-selected criteria.

Panelling where the sample is kept for subsequent investigations, so trends are easier to spot.

Surveying by post the mail shot method. Unfortunately the sample becomes self-selecting and so may be biased.

Observation e.g. through the use of cameras within supermarkets to examine how long customers spend on reading the nutritional information on food packaging.

Quantitative methods of incorporating risk and uncertainty

In addition to the research techniques discussed, the following methods can be used to address risk or uncertainty. To access these either click on the links below or on the relevant part of the above diagram.

Sensitivity Analysis looks at varying key estimates to see how much safety margin we have before the decision we are making will change. For example, based on a selling price of £5 a project is worthwhile but if it drops by more than 10% to below £4.50, then the project should be rejected.

Simulation is a method where random numbers are used to generate different possible scenarios, which can then be solved. The process is re-run many times to then get an idea of the spread of possible outcomes

Expected Values (EV) are essentially averages. For example, instead of saying that is an equal probability that sales could be 100,000 or 150,000 units (two possibilities) we solve the problem using an average of 125,000 units (one estimate).

Payoff tables are a simple way of showing the different possible scenarios and their respective payoffs - i.e. the profit or loss of each.

Maximax, maximin and minimax regret are different perspectives that can be applied to payoff tables. Once we know the different possible outcomes we can identify which decision is best for a particular investor based on their risk aversion.

Decision Trees are a way of representing more complex decisions, probabilities and outcomes.

    Created at 6/1/2012 3:03 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
    Last modified at 11/14/2012 2:49 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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    risk;uncertainty;upside potential;downside exposure;focus groups;desk research;field research;motivational research;measurement research

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