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Risk is where we have various possible outcomes from the money invested (maybe in a project) and probabilities can be determined based on past experience to reduce the riskiness from the investment.
Uncertainty is where we have various possible outcomes from the investment but probabilities cannot be determined because there is no past experience.
I have two questions here:
(1) We have different decision-makers who have different attitudes towards risk (i.e. risk seekers / risk aversers / risk neutrals) who adopt different approaches (i.e. maximax / maximin / minimax / expected value / perfect information / decision tree) BUT all these approaches are used to reduce risk or uncertainty?
(2) Throughout the Risk and Uncertainty chapter in the notes all approaches are used to reduce the risk from the investment but not uncertainty. And I find it hard to accept because only (expected value / perfect information / decision tree) approaches determine probabilities for the possible outcomes and therefore take probabilities in the calculations. So only these approaches should be used to reduce the uncertainty.
However, approaches like (maximax / maximin / minimax) does not determine probabilities for the possible outcomes and therefore do not take probabilities in the calculations. So only these approaches should be used to reduce the risk.
What I said above is all true?
None of the approaches reduce the risk or the uncertainty.
The risk exists whichever approach is taken. How the decision maker reacts to risk determines which of the approaches he or she is likely to prefer.
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All the rest is correct? Especially what I wanted to know dearly is that :
1) Since approaches like (expected value / perfect information / decision tree) determine probabilities for the possible outcomes and therefore take probabilities in the calculations. So only these approaches should be used by the decision-makers to react to the uncertainty in the investment project.
2) However, approaches like (maximax / maximin / minimax) do not determine probabilities for the possible outcomes and therefore do not take probabilities in the calculations. So only these approaches should be used by the decision-makers to react to the risk in the investment project.
3) The reason I asked you this again is that risk definition says that risk is where we have various possible outcomes and probabilities can be determined. And we know that the approaches mentioned in (1) are where we have given probabilities.
BUT the uncertainty definition says that uncertainty is where we have various possible outcomes but probabilities cannot be determined. So we know that the approaches mentioned in (2) are where we do not have given probabilities.
Thanks for reply.
You are correct in that we can only use an expected value approach if the probabilities are known.
However even if the probabilities are known, decision makes may still prefer to use one of the other approaches.
Suppose I offered you a lottery ticket that cost $100 and gave you a 1% chance of winning $100,000 and a 99% change of winning nothing (and you could only by one ticket). The expected return is $1,000 and it only costs $100, so on expected values you would buy it.
But would everyone decide to buy it? Would you risk losing $100 when you are 99 times more likely to lose than to win? It depends on the amounts involved and the way you react to the risk.
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