risky models
DESCRIPTION
Risk models are a normal part of decision making. This presentation suggests that most people are poor at judging probabilities, and that risk and loss aversion are strong behavioral modifiers which affect decisions.TRANSCRIPT
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Risky Models
Palisade EMEA2012 Risk ConferenceLondon
© 2012 Captum Capital Limited
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Modelling Risk
Estimate probability of future eventsProbabilities based on:Statistical analysis of historic dataExpert opinionWisdom of crowdsSubjective best guess
Risk models used to make decisions
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Subjective Risk Perception
Decision makers:Have a poor appreciation of probabilitiesAre risk averseAre loss averse
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US Masters 2012
Sudden Death Play-off
Final 10th Hole – Camilla Par 4
Augusta National
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10th Hole Playoff
Louis Oosterhuizen (South Africa)
Reached green in 3 shots
15 feet from pin
Bubba Watson (United States)
Reached green in 2 shots
8 feet from pin
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Bubba Wins!
Oosterhuizen – Bogey 5
Watson – Par 4
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H T
0.5 + 0.5 = 1
Toss a coin...
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Risk Perceptions
1. 2.
3. 4.
P=1.0£100
0.75
0.25
£300
- £500
0.5
0.5
£500
- £300
0.25
0.75
£700
- £100
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650 Perceptions
1. 2.
3. 4.
P=1.0£100
0.75
0.25
£300
- £500
0.5
0.5
£500
- £300
0.25
0.75
£700
- £100
14% 26%
35% 26%
© Dr. Kelvin Stott
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Loss AversionUtility
ProfitLoss
£100
- £100
Prospect Theory
Kahneman & Tversky (1974)
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Multiple Milestones
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TAMIX Option Value
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Tamix Option Cash Flow
Year 0 1 2 3 4
Cash Flow -1.00 0 -12.55 0 157.35
P 1 0.5 0.5x0.9
NPV -1.00 -10.00 100.00
rNPV = -1 + 0.5 x -10 + 0.45 x 100= £39,000,000
Cash Flow in £000s
Discount Rate R = 12%
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@Risk Option Value
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TAMIX Model Output
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What does it mean?
rNPV $million) Probability of Happening
-1.00 50%
-6.00 5%
39.00 45%
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Risk Impact Matrix
Insignificant
1Minor
2Moderate
3Major
4Catastrophic
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Rare 1 1 2 3 4 5
Unlikely 2 2 4 6 8 10
Possible 3 3 6 9 12 15
Likely 4 4 8 12 16 20
Certain 5 5 10 15 20 25
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NHS Risk Assurance
All NHS Trusts are required to have a Risk Assurance FrameworkHow useful is it?Different people assign different risk
probabilities & impactsNon-quantifiable risks
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NHS Risk Examples
Risk Risk Rating Real Risk
Service demand exceeds contract budgetLikely 4 Impact 5
[Finance Director]
20 25
EWTD limits availability of junior doctorsCertain 5 Impact 4
[Medical Director]
20 10
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The Monty Hall Problem
Originally proposed by:Steve Selvin in the American Statistician 1975
Named after:Monty Hall, hostLet’s Make a Deal
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The Game
Three doors; one hides a car, the others hide goats
You choose one of the 3 doors The host opens a door you haven’t
chosen to reveal a goat Should you stick with your original
choice – or swap?
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Monty Hall @ Risk Model
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The logic of the problem
£ 0 0
0 £ 0
0 0 £
£ 0 0
0 £ 0
0 0 £
Stick Swap
1:3 chanceto win
2:3 chanceto win
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Decision Tree Solution
Host opens
Total P
Stay Switch
Door 2 1 / 6 Car Goat
Door 3 1 / 6 Car Goat
Door 3 1 / 3 Goat Car
Door 2 1 /3 Goat Car
CarLocation
Door 1
Door 2
Door 3
1 / 2
1 / 2
1
1
Player picks
Door 1
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A Controversial Game
A newspaper column received several thousand complaints about this solution
Experiments show ~80% think there is no difference between staying or switching
Even after training in probability, ~70% still choose the wrong answer
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St Petersburg paradox
Daniel Bernoulli
1700 -1782
Presented the problem and its solution in Commentaries of the Imperial Academy of Science of Saint Petersburg (1738)
The problem was invented by Daniel's cousin Nicolas Bernoulli who first stated it in a letter to Pierre Raymond de Montmort of 9 September 1713
The paradox is a classic problem in probability and decision theory, based on a lottery game
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The game
You start with £1A coin is tossed:Heads – your stake is doubledTails – game over
Keep tossing the coin as long it comes up heads
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Some plays
Payout
1 T £1
2 H – H - T £4
3 H – H – H - T £8
4 H – H – H – H – H - T £32
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What’s the problem?
The Expected Value of the game is unlimited!
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Heads Model
Head?
N=N+1
N=0
End
No
Yes
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1000 Plays
0
100
200
300
400
500
600
0 1 2 3 4 5 6
# Heads
Average Payout per Play £3.30
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Payout
# Heads % Plays Payout0 50 £11 27 £22 12 £43 7 £84 2 £165 2 £326 0.5 £64
16 ~0.0002 £65536
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Summary
Risk Models depend on Probabilities!Decision makers:Have a poor appreciation of probabilitiesAre risk averseAre loss averse
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About Captum
Innovation in Life Sciences
Technology Valuation
Modelling behaviour, innovation, value
See us at
Licensing
Risk Analysis using
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Contact
Michael Brande: [email protected]: +44 (0) 115 988 6154m: +44 (0) 7980 257 241
Captum Capital LimitedCumberland House35 Park RowNottingham NG1 6EEUnited Kingdom
www.captum.com