APPLICATIONS OF PROBABILITY
- Finance – In finance, probabilities are used in Monte Carlo simulations, which can help assess possible risk impacts on real-life scenarios such as stock prices and company/sector revenue. They also help estimate the likelihood of meeting long-term investment goals. This feature is particularly true in the goals-based approach to asset allocations, wherein more important goals are assigned higher probabilities of success in the asset allocation process, and lower chances of success are given to less important goals. Probability is also used in bankruptcy prediction models such as the Altman Z-Score and in determining insurance premiums. The latter, for example, implies that the more likely you are to run into an accident, the higher the insurance premium you are likely to pay.
- Marketing – Market research helps organisations identify probabilities and make decisions using solid data. It can help the product marketer determine how many units to buy without worrying about a high risk of overstocking. This feature ultimately reduces the likelihood of making wrong moves. In marketing, the use of probabilities is also evident in split tests, wherein, for instance, two or more ads are tested simultaneously before a decision is made on which of the ads to roll out to the public. In the testing phases, the ads’ click-through rates are compared in a series of iterative processes until the advertisement with the greatest probability of success is identified. The ‘winning ad’ must have emerged with more click-through rates across the iterative test processes, each of which is expected to feature slight modifications such as colour change and adjustments to fonts.
- Operations – In operations, probabilities are used in estimating project completion time. For instance, Project Evaluation Review Techniques (PERT) assume project completion time follows a normal probability distribution. Likelihood of occurrence is also used to ascertain reliability (the possibility that a component will perform its function for a specified period when operating in its design environment). Reliability helps to predict, analyse, prevent, and mitigate failures over time.
- Logistics – Probability is used to ascertain the likelihood of a stock out (addresses whether what you have can meet estimated demand) and how much you should produce to meet a certain amount. Probability is deployed to weather predictions, which may impact products or raw material shipping at different periods. This information can help an organisation decide on appropriate periods to place replenishment orders or move its raw materials.
- Managerial decisions – Probability helps to ascertain the degree of risks in business decisions. Given the inherent risks in businesses, probability teaches managers the dangers of overweighting a single outcome (i.e. it may be an outlier or may not be a certainty in the future). Therefore, probability teaches managers to aim for a range of outcomes centred around the mean (i.e. more likely outcome). It is easier to hit a range of outcomes than a single one. #MEMBA11
