Of scenario thinking, expected value, and mitigating downside


Image from advisoranalyst.com

What do you consider when making a major decision, especially one that is shrouded in uncertainty? Most difficult decisions are as such because we cannot be sure of the outcome, and the cost of failure may be high. Yet, the cost of not making the decision may be even higher. So, it seems like we are in between a rock and a hard place. So how do we manage that? In this article, we share three major thought considerations to manage risk, and to help you make the right decision every time.

Scenario thinking

If you are unsure of the outcome of a decision, you should assess its variability. You can do that by applying scenario thinking – by painting the best-case, worst-case and most-likely case scenarios to the situation. You do this by first listing down all your assumptions pertaining to the decision option, and then paint the scenario when all your assumptions were correct, leading to the best-cased scenario. The worst-case scenario is one where all your assumptions were wrong. And finally, the most likely scenario is, as it says, the scenario where your assumptions would most likely occur.

Expected value

To make your decision more robust, you could assign probabilities to each of the scenarios and multiply those with the expected return for that scenario. The expected value of the decision is the sum total of these values. Let’s say, for example, that you expect the worst-case scenario of a decision to lead to a loss of $7,800, the best case to lead to a profit of $14,000, and the most-likely case to lead to a profit of only $500. Let us also say that the probability of the worst case scenario happening is 38%, the best case is 18% and the most likely is 44% (they must all add up to 100%), then we can calculate the expected value of the decision based on their expected return, as such:

Expected value = (-7800 x 0.38 + 14000 x 0.18 + 500 x 0.44) = -244.

In this case, this is not a good option since the expected value is negative; and if we cannot do anything about the downside, it should be given a miss. A good decision is one with positive expected value, and the higher the positivity, the better the decision.

Mitigating downside

So what happens if all your options yield a negative expected value? Obviously the best decision would be the one with the least negative value. But that seems like a poor choice as well. Why would a person want to go into a decision that will have a negative expected value, even if there was a need to go into such a decision? To manage this, the decision maker should look at improving the odds by mitigating the downside, by pouring in more resources to make it work. Alternatively, he could also increase the likelihood of the best case or most likely-case scenarios by securing contracts before inking the deal. Anything to increase the positive and limiting the negative returns will make the option less risky, and to ensure that the decision is the right one.

Making a decision in uncertainty does not need to be a stab in the dark. Understanding scenarios, expected value and mitigating downside will all help you make the right decision every time. There are limitations to all these, of course, but in the absence of any other information, these offer a sense of where we should be placing our bets. And decisions are becoming more and more uncertain in a dynamic economy such as Singapore’s.

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