MONEY

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MONEY, MONEY, MONEY

Money is special.  Decision theory is most often used for business decision making.  In fact, more research has been completed on monetary decisions than any other decision type.  Most business decision making use the single attribute money.  This clearly simplifies models where gains and losses, purchases or other financial issues are being evaluated. 

 

EXPECTED VALUE

Most money problems are resolved by computing the expected value of all alternatives and selecting the alternative with the highest expected value.  To compute expected value you multiple the payoff for each outcome of an alternative by the probability of occurrence.  A simple example is a coin flip.  For the decision making tree shown in Figure 1, the expected value for the Donít Bet decision is zero.  The computed expected monetary value, EV, of the Bet decision is: 

EV = $10 x 0.5 - $10 x 0.5 = 0

Incredibly both alternatives, either Bet or Donít Bet, have an expected value of zero.  So, a risk neutral person would be indifferent to betting or not.

 

RISK SEEKERS

Not everyone behaves like a risk neutral individual.  Some people love to take risks even when they donít seem rational.  These are risk seeking individuals.  The expected value of the alternative they select may not have the highest expected value.  For instance, a gambler may be willing to bet $10 on a coin toss to win $5.  The decision tree example for this type of bet is shown in Figure 2.  The expected value for the bet alternative is: 

EV = $5 x 0.5 - $10 x 0.5 = -$5 

The bet has a expected loss over the long run of $5.  Now you may think no one would place this bet.  Well have you ever bought a lottery ticket?  If the payoff after taxes was not at least $50 to $60 million you probably placed a risk seeking bet.

 

RISK ADVERSE 

A risk adverse person is the opposite of a risk seeker.  A risk adverse person wants the payoffs in his or her favor.  For our example coin toss, the risk adverse person would want to win $10 if he or she takes the risk of losing $5.  Figure 3 shows a decision making tree with this type of bet.  The expected monetary value of the bet alternative is: 

EV = $10 x 0.5 - $5 x 0.5 = $5

Most of us are risk adverse at some level of risk.  For instance, you may not be willing to bet $10,000 on a coin flips when the payoff is also $10,000, even though the expected value for this bet would be: 

EV = $10,000  x  0.5 - $10,000 x  0.5 = 0

So, a risk neutral person would be indifferent to the bet as shown in Figure 1.  But now the stakes are too high for many and it would not be uncommon for someone to be adverse to betting. 

 

RISK PREFERENCE 

The previous examples of risk neutral, risk seeking, and risk adverse decision makers were quite simple.  To model the decision makers risk preference correctly in a multiple outcome decision, the outcomes or payoffs need to be replaced on the decision tree with Satisfaction Levels from the decision maker.  Typically a Satisfaction Level of 1 or 100 is assigned to the highest payoff and 0 is assigned to the lowest payoff.  The Satisfaction Level for other payoffs depends upon the decision makers preferences (risk neutral, risk seeking, or risk adverse).

 

If you are facing decisions on gains or losses or purchases or other financial decisions, then there is help.

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