Decision Making Under Risk

A situation where one chooses to consider the possible outcomes with theirs probability of occurrence. Probability Distribution and Expected Value Criterion principles used. Probabilities determined objectively from Past Records or subjectively using Experience and Judgement. Maximum Likelihood Principle Expectation Value Principle

Maximum Likelihood Principle

Used when past records may not be available. Uses experiential judgement to define pay offs.

Consider event which is most likely to occur.

Then deciding course with maximum pay offs.

Final decision

Has the demerit of ignoring information i.e. neglecting other possible events and consequences

Expected Value Criterion

It seeks the maximization of expected profits or minimization of expected costs. The payoff associated with each decision is probabilistic.

Decision problem involving n events & m strategies. = j=1,2,m =1 aij = payoff from ith event and jth act pi = probability of ith event
You want to invest $10000 either in stock A or stock B. Stock A is risky with 50% ROI in bull market but -20% in bear market. Stock B is safe with 15% ROI in bull market & 5% in bear. Most of the consultancies predict 60% chances on bull & 40% market in the coming financial year. Decision : Where to invest your Money ?

Example