General

Decision Analysis

Adeyemi Adegbite Written by Adeyemi Adegbite · 1 min read >

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Introduction

When life throws a curveball at us, it presents us with options and a decision to make. It is often said that the hardest part of solving a problem is accurately defining it. And the most powerful form of hard work is thinking clearly. Designing a winning strategy may not look very active but it is a lot of work. Decision analysis is employed to develop an optimal strategy when an individual is faced with multiple decision alternatives and an uncertain future event. When they occur, the uncertain future event always impacts the outcome of the decision one way or the other. Hence the critical need for consideration of future events in decision analysis. Summarily, a decision problem is characterized by decision alternatives, state of nature (uncertain future event), and resulting payoff (outcome). Typically, some tools used in decision analysis include influence diagram, decision tree, and payoff table.

Criteria and Approaches

There are situations where information about the future event won’t be available, three possible criteria can be applied to decision making. One of such criteria is the optimistic approach. This approach applies largely to people who always see the glass half full. They don’t believe the future event won’t impact them negatively. They generally will opt for the decision option with the largest payoff or the least cost. The second criterion is the conservative approach. This approach is for people who can tolerate some risk but yet play it safe. Amongst the least favorite payoffs, the maximum value is usually selected. The third is the minimax regret approach. This is meant for risk-averse people. They determine the risk or regret of all the decision options and select the option with the least risk or regret.

Bring it Home

To bring this home with an example, you are in the construction industry are considering a real estate investment. The architect presented 3 possible structures for your consideration, a 30, 60, or 90 condominium complex. The financial success of this project depends on the size of the condominium and the future events concerning the demand for condominiums.  This future event can largely be influenced by the economic situation in the country. Using the influence diagram, it is clear that the future demand for condominiums and the size of the complex directly determine the profit of the investment.  Investigation showed that if the future demand is strong, the investor could walk away with $8 million for the 30 condominiums, $14 million for the 60 condominiums, and $20 million for the 90 condominium complex. However, if the future demand is weak, the investor could walk away with $7 million profit, $5 million profit, or a loss of $9 million for the 30, 60, or 90 condominiums respectively.

The optimistic investor will naturally invest in the 90 condominium complex simply because of the huge $20 million profit. The conservative investor will consider the weak future demand as opt for the highest returns. This leads to investment in the 30 condominium complex. The minimax investor who is risk-averse will compute the regret table and select the option with the minimum regret. This led the investor to invest in the 60 condominium complex.

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