Role of Decision Analysis
• The purpose of business analytics is to provide decision-
makers with information needed to make decisions.
• Making good decisions requires an assessment of
intangible factors and risk attitudes.
• Decision analysis is the study of how people make
decisions, particularly when faced with imperfect or
uncertain information, as well as a collection of techniques
to support decision choices.
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Formulating Decision Problems
• Many decisions involve making a choice between a small set of decisions with
uncertain consequences.
• Decision problems involve:
1. decision alternatives
2. uncertain events that may occur after a decision is made along with their
possible outcomes (which are often called states of nature), and are
defined so that one and only one of them will occur.
3. consequences associated with each decision and outcome, which are
usually expressed as payoffs. Payoffs are often summarized in a payoff
table, a matrix whose rows correspond to decisions and whose columns
correspond to events.
– The decision maker first selects a decision alternative, after which one of
the outcomes of the uncertain event occurs, resulting in the payoff.
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Example 16.1: Selecting a Mortgage
Instrument
• A family is considering purchasing a new home and wants to finance
$150,000. Three mortgage options are available and the payoff table for the
outcomes is shown below. The payoffs represent total interest paid under
three future interest rate situations.
Decision Outcome: Rates Outcome: Rates Outcome: Rates
Rise Stable Fall
1-year ARM $61,134 $46,443 $40,161
3-year ARM $56,901 $51,075 $46,721
30-year fixed $54,658 $54,658 $54,658
– The best decision depends on the outcome that may occur. Since you
cannot predict the future outcome with certainty, the question is how to
choose the best decision, considering risk.
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Decision Strategies Without Outcome
Probabilities: Minimize Objective
• With a minimize objective, the payoffs are costs.
• Aggressive (Optimistic) Strategy
– Choose the decision that minimizes the smallest payoff that can
occur among all outcomes for each decision (minimin strategy).
• Conservative (Pessimistic) Strategy
– Choose the decision that minimizes the largest payoff that can
occur among all outcomes for each decision (minimax strategy).
• Opportunity Loss Strategy
– Choose the decision that minimizes the largest opportunity loss
among all outcomes for each decision (minimax regret)
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Example 16.2: Mortgage Decision
with the Aggressive Strategy
• Determine the lowest payoff (interest cost) for each type of
mortgage, and then choose the decision with the smallest
value (minimin).
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Example 16.3: Mortgage Decision
with the Conservative Strategy
• Determine the largest payoff (interest cost) for each type of
mortgage, and then choose the decision with the smallest
value (minimax).
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Understanding Opportunity Loss
• Opportunity loss represents the “regret” that people often
feel after making a nonoptimal decision.
• In general, the opportunity loss associated with any
decision and event is the difference between the best
decision for that particular outcome and the payoff for the
decision that was chosen.
– Opportunity losses can be only nonnegative values.
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Example 16.4: Mortgage Decision with
the Opportunity-Loss Strategy (1 of 2)
• Compute the opportunity loss matrix.
Step 1:Find
the best
outcome
(minimum
cost) in each
column.
Decision Outcome: Rates Outcome: Rates Outcome: Rates
Step Rise Stable Fall
2:Subtract the
1-year ARM $6,476 $− $−
best column
3-year ARM $2,243 $4,632 $6,560
value from
each value in 30-year fixed $− $8,215 $14,497
the column.
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Example 16.4: Mortgage Decision with the
Opportunity-Loss Strategy (2 of 2)
• Find the “minimax regret” decision
Step 3: Determine the maximum opportunity loss for each decision, and
then choose the decision with the smallest of these.
• Using this strategy, we would choose the 1-year ARM. This ensures
that, no matter what outcome occurs, we will never be more than
$6,476 away from the least cost we could have incurred.
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Decision Strategies Without Outcome
Probabilities: Maximize Objective
• With a maximize objective, the payoffs are profits.
• Aggressive (Optimistic) Strategy
– Choose the decision that maximizes the largest payoff that can occur
among all outcomes for each decision (maximax strategy).
• Conservative (Pessimistic) Strategy
– Choose the decision that maximizes the smallest payoff that can occur
among all outcomes for each decision (maximin strategy).
• Opportunity Loss Strategy
– Choose the decision that minimizes the maximum opportunity loss among
all outcomes for each decision (minimax regret).
▪ Note that this is the same as for a minimize objective; however,
calculation of the opportunity losses is different.
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Decisions with Conflicting Objectives
• Many decisions require some type of tradeoff among conflicting objectives,
such as risk versus reward.
• A simple decision rule can be used whenever one wishes to make an optimal
tradeoff between any two conflicting objectives, one of which is good, and
one of which is bad, that maximizes the ratio of the good objective to the bad.
– First, display the tradeoffs on a chart with the “good” objective on the x-
axis, and the “bad” objective on the y-axis, making sure to scale the
axes properly to display the origin (0,0).
– Then graph the tangent line to the tradeoff curve that goes through the
origin.
– The point at which the tangent line touches the curve (which represents
the smallest slope) represents the best return to risk tradeoff.
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Example 16.5: Risk-Reward Tradeoff
Decision for Innis Investments Example
• From Figure 15.2, if we take the ratios of the weighted returns to the
minimum risk values in the table, we will find that the largest ratio
occurs for the target return of 6%.
• We can explain this easily from the chart by noting that for any other
return, the risk is relatively larger (if all points fell on the tangent line,
the risk would increase proportionately with the return).
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Summary of Decision Strategies
Under Uncertainty (1 of 2)
Objective Strategy Aggressive Conservative Opportunity-Loss
Strategy Strategy Strategy
Minimize Choose the Find the smallest Find the largest pay- For each outcome,
objective decision with payoff for each deci- off for each decision cornpute the
the smallest Sion among all Out- among all Outcomes opportunity loss for
average payoff. comes and choose and choose the each decision as
the decision with the deci-Sion with the the absolute
smallest of these smallest of these difference between
(minim in). (minimax). its payoff and the
smallest payoff for
that outcome. Find
the maximum
opportunity loss for
each decision and
choose the decision
with the smallest
opportunity loss
(minimax regret).
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Summary of Decision Strategies
Under Uncertainty (2 of 2)
Objective Strategy Aggressive Conservative Opportunity-Loss
Strategy Strategy Strategy
Maximize Choose the Find the largest Find the smallest For each outcome,
objective decision with pay-off for each pay- compute the
the largest decision off for each opportunity loss for
average payoff. among all decision each decision as
outcomes among all the absolute
and choose the outcomes difference between
decision with the and choose the its payoff and the
largest decision with the largest payoff for
of these largest of that outcome. Find
(maximax). these (maximin). the maximum
opportunity loss for
each decision and
choose the
decision with the
smallest
opportunity loss
(minimax regret).
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Decision Strategies with Outcome
Probabilities
• In many situations, we might have some assessment of these
probabilities, either through some method of forecasting or reliance on
expert opinions.
• If we can assess a probability for each outcome, we can choose the
best decision based on the expected value.
– The simplest case is to assume that each outcome is equally likely
1
to occur; that is, the probability of each outcome is N
,
where N is the number of possible outcomes. This is
called the average payoff strategy.
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Example 16.6: Mortgage Decision
with the Average Payoff Strategy
• Estimates for the probabilities of each outcome are shown
in the table below.
• For each loan type, compute the expected value of the
interest cost and choose the minimum.
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Expected Value Strategy
• A more general case is when the probabilities of the
outcomes are not all the same. This is called the expected
value strategy.
• We may use the expected value calculation that we
introduced in formula (5.12) in Chapter 5.
E X = xi f ( xi ) (5.12)
i =1
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Example 16.7: Mortgage Decision
with the Expected Value Strategy
• Estimates for the probabilities of each outcome are shown
in the table below.
• For each loan type, compute the expected value of the
interest cost and choose the minimum.
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Evaluating Risk
• An implicit assumption in using the average payoff or
expected value strategy is that the decision is repeated a
large number of times. However, for any one-time decision
(with the trivial exception of equal payoffs), the expected
value outcome will never occur-only one of the actual
outcomes will occur for the decision chosen.
• For a one-time decision, we must carefully weigh the risk
associated with the decision in lieu of blindly choosing the
expected value decision.
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