Risk – Exposure to Gain and Loss

This entry is part 4 of 6 in the series Monte Carlo Simulation


It is first when the decision involves consequences for the decision maker he faces a situation of risk. A traditional way of understanding risk is to calculate how much a certain event varies over time. The less it varies the minor the risk. In every decision where historical data exists we can identify historical patterns, study them and calculate how much they varies. Such a study gives us a good impression of what kind of risk profile we face.

  • Risk – randomness with knowable probabilites.
  • Uncertainty – randomness with unknowable probabilities.

Another situation occurs when little or no historical data is available but we know fairly well all the options (e.g. tossing a dice). We have a given resource, certain alternatives and a limited number of trials. This is equal to the Manahattan project.

In both cases we are interested in the probability of success. We like to get a figure, a percentage of the probability for gain or loss. When we know that number we can decide whether we will accept the risk or not.

Just to illustrate risk, budgeting makes a good example. If we have five items in our budget where we have estimated the expected values (that is 50% probability) it is only three percent probability that all five will target their expectation at the same time.

0.5^5 = 3,12%

A common mistake is to summarize the items rather than multiplying them. The risk is expressed by the product of the opportunities.

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S@R develops models for support of decision making under uncertainty. Taking advantage of recognized financial and economic theory, we customize simulation models to fit specific industries, situations and needs.

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