Risk Analysis / Decision Tree

RISK ANALYSIS / DECISION TREE
 Decision Trees are visual

representations of the
average outcome.
 Decision Trees are excellent
tools for helping you to
choose between several
courses of action.
Decision Tree
WHAT IS A DECISION TREE?
 A Visual Representation of Choices,

Consequences, Probabilities, and
Opportunities.
 A Way of Breaking Down Complicated
Situations Down to Easier-to-
Understand Scenarios.
Decision Tree
 A decision tree is a map of the possible outcomes of a series
of related choices. It allows an individual or organization to
weigh possible actions against one another based on their
costs, probabilities, and benefits.
 As the name goes, it uses a tree-like model of decisions. They
can be used either to drive informal discussion or to map out
an algorithm that predicts the best choice mathematically.
 A decision tree typically starts with a single node, which
branches into possible outcomes. Each of those outcomes
leads to additional nodes, which branch off into other
possibilities. This gives it a tree-like shape.
ADVANTAGES OF DECISION TREES
ADVANTAGES
- generate understandable rules.
- perform classification without requiring much computation.
-are capable of handling both continuous and categorical variables.
- provide a clear indication of which fields are most important for

prediction or classification.
NOTATION USED IN DECISION TREES
 A box is used to show a choice that the

(square) manager has to make
 A circle is used to show that a probability

outcome will occur.
 Lines connect outcomes to their choice

or probability outcome.
DRAWING A DECISION TREE
 You start a Decision Tree with a decision that you need to make. Draw a
small square.
 From this box draw out lines towards the right for each possible
solution, and write that solution along the line.
 At the end of each line, consider the results. If the result of taking that
decision is uncertain, draw a small circle. If the result is another
decision that you need to make, draw another square. Squares
represent decisions, and circles represent uncertain outcomes. Write
the decision or factor above the square or circle. If you have completed
the solution at the end of the line, just leave it blank.
 Starting from the new decision squares on your diagram, draw out lines
representing the options that you could select. From the circles draw
lines representing possible outcomes. Again make a brief note on the
line saying what it means. Keep on doing this until you have drawn out
as many of the possible outcomes and decisions as you can see
leading on from the original decisions.
DECISION TREE EXAMPLE
onomy
d Ec
Goo
Buy
Bad
Ec o
nom
y y
o m
on
Ec
od
Go
Don’t buy
Ba
dE
c on
om
y
EVALUATING YOUR DECISION TREE
 Now you are ready to evaluate the decision tree. This is where
you can work out which option has the greatest worth. Start by
assigning a cash value or score to each possible outcome.
Estimate how much you think it would be worth to you if that
outcome came about.
 Next look at each circle (representing an uncertainty point) and
estimate the probability of each outcome. If you use
percentages, the total must come to 100 percent at each circle. If
you use fractions, these must add up to 1.
y 0,8 5000 $
no m
d E co
Goo
Buy
Bad
Ec o
n om
y0 -1000 $
,2
y 0 ,7
n om 5000 $
co
o dE
Go
Don’t buy
Ba
dE
c on
om
y0
,3 -2000 $
CALCULATING TREE VALUES
 Start on the right hand side of the decision tree, and work back
towards the left.
 Where you are calculating the value of uncertain outcomes
(circles on the diagram), do this by multiplying the value of the
outcomes by their probability. The total for that node of the tree
is the total of these values.
 In the example, the value for “buy" is:
 0.8 (probability good economy) x $5000(value) =$4000
 0.2 (probability bad economy) x (-1000$ (value))=$-200
 TOTAL $3800
y 0,8 5000 $
no m
d E co
3800 $ Goo
Buy
Bad
Ec o
n om
y0 -1000 $
,2
y 0 ,7
n om 5000 $
2900 $ co
o dE
Go
Don’t buy
Ba
dE
c on
om
y0
,3 -2000 $
EASY EXAMPLE
 A Decision Tree with two choices.
Go to Graduate School to get my

MBA (NPV (= $425,000)
max
Go to Work “in the Real World”

NPV = $410,000
Is this a realistic model?
What is missing? Go to Business School
EXAMPLE 1
Mary is a manager of a gadget factory. Her factory has
been quite successful the past three years. She is
wondering whether or not it is a good idea to expand her
factory this year. The cost to expand her factory is $1.5M. If
she does nothing and the economy stays good and people
continue to buy lots of gadgets she expects $3M in revenue;
while only $1M if the economy is bad.
If she expands the factory, she expects to receive $6M if
economy is good and $2M if economy is bad.
She also assumes that there is a 40% chance of a good
economy and a 60% chance of a bad economy.
(a) Draw a Decision Tree showing these choices.
40 % Chance of a Good Economy

.4 Profit = $6M
Expand Factory
Cost = $1.5 M
.6 60% Chance Bad Economy
Profit = $2M
Good Economy (40%)

.4 Profit = $3M
Don’t Expand Factory
Cost = $0 .6 Bad Economy (60%)
Profit = $1M
NPVExpand = (.4(6) + .6(2)) – 1.5 = $2.1M
NPVNo Expand = .4(3) + .6(1) = $1.8M

$2.1 > 1.8, therefore you should expand the factory
EXAMPLE 2 – JOE’S GARAGE
Joe’s garage is considering hiring another mechanic. The
mechanic would cost them an additional $50,000 / year in
salary and benefits. If there are a lot of accidents in
Providence this year, they anticipate making an additional
$75,000 in net revenue. If there are not a lot of accidents,
they could lose $20,000 off of last year’s total net
revenues. Because of all the ice on the roads, Joe thinks
that there will be a 70% chance of “a lot of accidents” and
a 30% chance of “fewer accidents”. Assume if he doesn’t
expand he will have the same revenue as last year.
Draw a decision tree for Joe and tell him what he
should do.
EXAMPLE 2 - ANSWER
70% chance of an increase

.7 in accidents
Hire new
mechanic Profit = $70,000
.3 30% chance of a decrease
Cost = $50,000 in accidents
Profit = - $20,000
Don’t hire new

mechanic
Cost = $0
• Estimated value of “Hire Mechanic” =

NPV =.7(70,000) + .3(- $20,000) - $50,000 = - $7,000
• Therefore you should not hire the mechanic

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RISK ANALYSIS / DECISION TREE

 Decision Trees are visual

 A Visual Representation of Choices,

- generate understandable rules.

- perform classification without requiring much computation.

-are capable of handling both continuous and categorical variables.

- provide a clear indication of which fields are most important for

 A box is used to show a choice that the

 A circle is used to show that a probability

 Lines connect outcomes to their choice

 0.8 (probability good economy) x $5000(value) =$4000

 0.2 (probability bad economy) x (-1000$ (value))=$-200

 A Decision Tree with two choices.

Go to Graduate School to get my

Go to Work “in the Real World”

40 % Chance of a Good Economy

Good Economy (40%)

NPVExpand = (.4(6) + .6(2)) – 1.5 = $2.1M

NPVNo Expand = .4(3) + .6(1) = $1.8M

70% chance of an increase

Don’t hire new

• Estimated value of “Hire Mechanic” =

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