2/7/2014

Back to basics risk and probability: part one

Back to basics risk and probability: part one

August 2012
This is the first article in a two part feature by Bob Scarlett on risk, probability, uncertainty and sensitivity, of interest to students studying for or exempt from papers C03, C04, P1 and P2. Management accountants will often encounter situations in which decisions have to be made and plans constructed on the basis of uncertain data. That is where the outcome of course of action A is not known for sure or where element B can have a range of possible future values. A number of practices may be used to accommodate such uncertainties. These practices feature throughout the CIMA qualification, including papers C03 (fundamentals of business mathematics), C04 (fundamentals of business economics), P1 (performance operations) and P2 (performance management). The terms risk and uncertainty are sometimes used loosely and interchangeably in management literature. However, in this article, uncertainty will be considered to exist when a decision variable (an outcome or an element) can have a range of alternative future values and it is not possible to quantify the likelihood of any specific value occurring within that range. Risk is a condition of uncertainty where it is possible to attach quantified probabilities to given alternative future values. The term probability is normally expressed in the form of a number in the range 0 to 1. An impossible future value is stated to have a probability of 0. A certain future value is stated to have a value of 1. Where a number of future values are possible then the sum total of the probabilities of each value must add up to 1. A simple illustration of how probabilities can be stated is when we toss a coin 3 times, with a heads (H) or tails (T) result on each toss. Four outcomes are possible 3H & 0T, 2H & 1T, 1H & 2T, 0H & 3T. The probability of the first outcome (3H & 0T) is 0.125, that is 0.53 . This is so because probability of 1H is 0.5, so the probability of HHH in sequence must be 0.5 x 0.5 x 0.5. The probability of the second outcome (2H & 1T) is 0.375, that is 0.53 x 3. This is so because any one of three sequences (HHT, HTH and THH) can produce the outcome and the sum total of the probabilities of these sequences is (0.5 x 0.5 x 0.5) x 3. By weighting the values of the four outcomes with their individual probabilities we can calculate an expected outcome. In the above case this is as follows:

Outcome 3H & 0T 2H & 1T 1H & 2T

Probability 0.125 0.375 0.375

H x Pr. 0.375 0.750 0.375

T x Pr. 0.000 0.375 0.750

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2/7/2014

Back to basics risk and probability: part one

0H & 3T

0.125 total

0.000 1.50

0.375 1.50

The value of the expected outcome is 1.50H and 1.50T (that is, one and a half heads and one and a half tails). Clearly that is an impossible outcome, but it is a value that has some significance. If we were to toss the coin 3000 times then we would engage the law of large numbers and all risk would disappear. The outcome would be 1500H and 1500T, or very close to it. The expected value of a projects outcome represents the possible outcomes weighted by their probabilities. If the project is repeated many times then the expected value will be the actual average value generated. An understanding of expected value can be applied in a number of ways. Example Two alternative projects are under consideration. Project V has possible profit outcomes of GBP500 (0.6 probability) and GBP100 (0.4 probability). Project W has possible profit outcomes of GBP800 (0.7 probability) and GBP100 (0.3 probability). Required: Compare the expected outcomes of the two proposed projects. The expected values of profit to be generated by the two projects are as follows:

If project V were repeated 1,000 times then it would generate a profit of GBP500 on 600 occasions and GBP100 on 400 occasions, giving a total profit of GBP340,000 and an average profit of GBP340. Projects V and W can be compared on the basis of the expected value of their profits. If the two are alternatives then project W might be preferred on the basis of the higher expected value of its profit. However, the critical assumption in such a preference is that risk is eliminated by the projects being repeated a large number of times. The fact that project W has a wider spread of possible outcomes than project V need not be a matter of concern in this situation. If the alternative projects are both one-offs which will not be repeated, then greater consideration of risk is required. Example two Two alternative projects are under consideration. Project X has possible profit outcomes of GBP800 (probability 0.15), GBP1000 (0.50) and GBP1200 (0.35). Project Y has possible profit outcomes of GBP400 (probability 0.15), GBP1000 (0.50) and GBP1370 (0.35). Required: Compare the expected outcomes and risk profiles of the two projects. The expected profit values to be generated by the two projects are as follows:

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2/7/2014

Back to basics risk and probability: part one

The two projects have identical expected values of profit and on that basis alone we should be indifferent between them. However, if the two projects are both being run as one-offs then they involve different levels of risk. Project Y has a wider spread of possible outcomes than project X. The outcome spreads can be quantified using the standard deviation measure. The standard deviation (SD) of a set of n numbers (x1 to xn), where x is the average or expected value (you can use either), may be represented by the following equation:

How the equation is applied depends on the circumstances. In the case of project X, standard deviation based on the expected value of profit may be calculated as follows:

SD is the square root of GBP18,400. The SD figure of GBP136 is a measure of how dispersed the possible profit figures are around the GBP1040 expected profit. In this case, the standard deviation of the possible outcomes for project X is GBP136 while that for project Y is around GBP317. The spread of possible outcomes (and hence the associated standard deviation) for project Y is wider than that for project X which means that Y involves a higher level of risk than X. While in this particular case it is obvious that project Y has a wider spread of possible outcomes than project X, so we do not need to calculate standard deviations, in many practical cases it will not be so obvious and calculating standard deviations may be more useful. Which of the two projects, should the decision maker prefer if the two are mutually exclusive? That is, which of the two projects should be adopted if it is only possible to adopt one? To answer that, we need to understand the decision makers attitude to risk and reward. Specifically: 1. The risk averse investor would prefer X to Y. Both projects have the same expected profit outcome but Y involves greater risk. The risk averse investor will normally require a higher expected value for reward in order to justify accepting a higher level of risk. 2. The compulsive gambler (or risk seeker) would prefer Y to X. Both projects have the same expected value for profit outcome but Y offers the better best-case outcome. Management literature often assumes that all business decision makers and investors are risk averse. However, that may not be correct in every case.
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Back to basics risk and probability: part one

Many successful investors are gamblers by temperament. Various behavioural models exist which seek to categorise investors according to their attitude to risk and reward.

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