1.040/1.

401
Project Management
Spring 2006

Risk Analysis
Decision making under risk and uncertainty

Department of Civil and Environmental Engineering

Massachusetts Institute of Technology
 Preliminaries
 Announcements
 Remainder
 email Sharon Lin the team info by midnight, tonight
 Monday Feb 27 - Student Experience Presentation
 Wed March 1st – Assignment 2 due
 Today, recitation Joe Gifun, MIT facility
 Next Friday, March 3rd, Tour PDSI construction site
 1st group noon – 1:30
 2nd group 1:30 – 3:00
 Construction nightmares discussion
 16 - Psi Creativity Center, Design and Bidding
phases
Project Management Phase

FEASIBILITY DESIGN DEVELOPMENT CLOSEOUT OPERATIONS

PLANNING

Financing&Evalua
tion
Risk
Analysis&Attitude
 Risk Management Phase

FEASIBILITY DESIGN DEVELOPMENT CLOSEOUT OPERATIONS

PLANNING

RISK MNG
 Risk management (guest seminar 1st wk April)
 Assessment, tracking and control
 Tools:
 Risk Hierarchical modeling: Risk breakdown structures
 Risk matrixes
 Contingency plan: preventive measures, corrective
actions, risk budget, etc.
 Decision Making Under
Risk Outline
 Risk and Uncertainty
 Risk Preferences, Attitude and
Premiums
 Examples of simple decision trees
 Decision trees for analysis
 Flexibility and real options
Decision making
 Uncertainty and Risk
 “risk” as uncertainty about a
consequence
 Preliminary questions
 What sort of risks are there and who
bears them in project management?
 What practical ways do people use to
cope with these risks?
 Why is it that some people are willing to
take on risks that others shun?
 Some Risks
 Weather changes
 Different productivity
 (Sub)contractors are
 Unreliable
 Lack capacity to do work
 Lack availability to do
work
 Unscrupulous
 Financially unstable
 Late materials delivery
 Lawsuits
 Labor difficulties
 Unexpected
manufacturing costs
 Failure to find
sufficient tenants
 Community opposition
 Infighting &
acrimonious
relationships
 Unrealistically low bid
 Late-stage design
changes
 Unexpected subsurface
conditions
 Soil type
 Groundwater
 Unexpected Obstacles
 Settlement of adjacent
structures
 High lifecycle costs
 Permitting problems
 …
 Importance of Risk
 Much time in construction
management is spent focusing on risks
 Many practices in construction are
driven by risk
 Bonding requirements
 Insurance
 Licensing
 Contract structure
 General conditions
 Payment Terms
 Delivery Method
 Selection mechanism
 Outline
 Risk and Uncertainty
 Risk Preferences, Attitude and
Premiums
 Examples of simple decision trees

 Decision trees for analysis

 Flexibility and real options

Decision making under risk
Available Techniques
 Decision modeling
 Decision making under uncertainty
 Tool: Decision tree

 Strategic thinking and problem

solving:
 Dynamic modeling (end of course)
 Fault trees
Introduction to Decision
Trees
 We will use decision trees both for
 Illustrating decision making with
uncertainty
 Quantitative reasoning

 Represent
 Flow of time
 Decisions

 Uncertainties (via events)

 Consequences (deterministic or stochastic)

 Decision Tree Nodes
Time

 Decision (choice) Node

 Chance (event) Node

 Terminal (consequence) node

 Outcome (cost or benefit)
 Risk Preference
 People are not indifferent to uncertainty
 Lack of indifference from uncertainty arises
from uneven preferences for different outcomes
 E.g. someone may
 dislike losing $x far more than gaining $x
 value gaining $x far more than they disvalue losing
$x.
 Individuals differ in comfort with
uncertainty based on circumstances and
preferences
 Risk averse individuals will pay “risk
premiums” to avoid uncertainty
 Risk preference
 The preference depends on decision maker
point of view
 Categories of Risk
Attitudes
 Risk attitude is a general way of
classifying risk preferences
 Classifications
 Risk averse fear loss and seek sureness
 Risk neutral are indifferent to uncertainty
 Risk lovers hope to “win big” and don’t
mind losing as much
 Risk attitudes change over
 Time
 Circumstance
 Decision Rules
 The pessimistic rule (maximin = minimax)
 The conservative decisionmaker seeks to:
 maximize the minimum gain (if outcome = payoff)
 or minimize the maximum loss (if outcome = loss, risk)
 The optimistic rule (maximax)
 The risklover seeks to maximize the maximum gain
 Compromise (the Hurwitz rule):
 Max (α min + (1- α) max) , 0 ≤ α ≤ 1
 α = 1 pessimistic
 α = 0.5 neutral
 α = 0 optimistic
The bridge case – unknown
prob’ties
$ 1.09 million
replace

$1.61 M

repair
$0.55 Investment PV

$1.43
•Pessimistic rule
• min (1, 1.61) = 1 replace the bridge
•The optimistic rule (maximax)
• max (1, 0.55) = 0.55 repair … and hope it
works!
 The bridge case – known
prob’ties
$ 1.09 million
replace

$1.61 M
0.25
repair 0.5
$0.55 Investment PV
0.25
$1.43

Expected monetary value

E = (0.25)(1.61) + (0.5)(0.55) + (0.25)(1.43) =
$ 1.04 M

Data link
 The bridge case –
decision
 The pessimistic rule (maximin =
minimax)
 Min(Ei) = Min (1.09 , 1.04) = $
1.04 repair
 In this case = optimistic rule
(maximax)
 Awareness of probabilities change
risk attitude
 Other criteria
 Most likely value
 For each policy option we select the
outcome with the highest probability
 Expected value of Opportunity Loss
 To buy soon or to buy later
-100
Buy soon

Buy later -100-30+5 = -125

-100+5 = -95

-100+5+30 = -65

Current price = 100

S1 = + 30%
S2 = no price variation
S3 = - 30%

Actualization = 5
To buy soon or to buy later
-100
Buy soon

Buy later -125

0. 5
0.25
-95
0.25
-65
 The Utility Theory
 When individuals are faced with uncertainty they
make choices as is they are maximizing a given
criterion: the expected utility.

 Expected utility is a measure of the individual's

implicit preference, for each policy in the risk
environment.

 It is represented by a numerical value associated

with each monetary gain or loss in order to
indicate the utility of these monetary values to
the decision-maker.
 Adding a Preference
function
1.35

1
.7

125 100 65
Expected (mean) value
E = (0.5)(125) + (0.25)(95) + (0.25)(65) =
-102.5
Utility value:
f(E) = ∑ Pa * f(a) = 0.5 f(125) + 0.25 f(95) + .
25 f(65) =
 Defining the Preference
Function
 Suppose to be awarded a $100M
contract price
 Early estimated cost $70M

 What is the preference function of

cost?
utility

 Preference means utility or satisfaction

70 $
 Notion of a Risk
Premium
 A risk premium is the amount paid by a
(risk averse) individual to avoid risk
 Risk premiums are very common – what
are some examples?
 Insurance premiums
 Higher fees paid by owner to reputable
contractors
 Higher charges by contractor for risky work

 Lower returns from less risky investments

 Money paid to ensure flexibility as guard

against risk
 Conclusion: To buy or
not to buy
 The risk averter buys a “future”
contract that allow to buy at $ 97.38
 The trading company (risk lover) will
take advantage/disadvantage of
future benefit/loss
 Certainty Equivalent
 Example
Consider a risk averse individual with
preference fn f faced with an
investment c that provides Mean satisfaction with
 50% chance of earning $20000 .50
investment

 50% chance of earning $0 .25

 Average money from investment = Certainty equival

 .5*$20,000+.5*$0=$10000 of investment

 Average satisfaction with the

investment= Mean value
 .5*f($20,000)+.5*f($0)=.25 Of investme

 This individual would be willing to

trade for a sure investment yielding

$5000
satisfaction>.25 instead
 Can get .25 satisfaction for a sure f-
1(.25)=$5000

 We call this the certainty equivalent to the

investment
 Therefore this person should be willing to
trade this investment for a sure amount of
money>$5000
 Example Cont’d (Risk
Premium)
 The risk averse individual would be willing
to trade the uncertain investment c for any
certain return which is > $5000
 Equivalently, the risk averse individual
would be willing to pay another party an
amount r up to $5000 =$10000-$5000 for
other less risk averse party to guarantee
$10,000
 Assuming the other party is not risk averse,
that party wins because gain r on average
 The risk averse individual wins b/c more
satisfied
 Certainty Equivalent
 More generally, consider situation in which have
 Uncertainty with respect to consequence c
 Non-linear preference function f
 Note: E[X] is the mean (expected value) operator
 The mean outcome of uncertain investment c is E[c]
 In example, this was .5*$20,000+.5*$0=$10,000
 The mean satisfaction with the investment is E[f(c)]
 In example, this was .5*f($20,000)+.5*f($0)=.25
 We call f-1(E[f(c)]) the certainty equivalent of c
 Size of sure return that would give the same satisfaction
as c
 In example, was f-1(.25)=f-1(.5*20,000+.5*0)=$5,000
 Risk Attitude Redux
 The shapes of the preference functions
means can classify risk attitude by
comparing the certainty equivalent and
expected value
 For risk loving individuals, f-1(E[f(c)])>E[c]
 They want Certainty equivalent > mean outcome
 For risk neutral individuals, f-1(E[f(c)])=E[c]
 For risk averse individuals, f-1(E[f(c)])<E[c]
 Motivations for a Risk
Premium
 Consider
 Risk averse individual A for whom f-
1(E[f(c)])<E[c]

 Less risk averse party B

 A can lessen the effects of risk by paying a

risk premium r of up to E[c]-f-1(E[f(c)]) to B
in return for a guarantee of E[c] income
 The risk premium shifts the risk to B
 The net investment gain for A is E[c]-r, but A is
more satisfied because E[c] – r > f-1(E[f(c)])
 B gets average monetary gain of r
 Gamble or not to Gamble

EMV
(0.5)(-1) + (0.5)(1) = 0

Preference function f(-1)=0, f(1)=100

Certainty eq. f-1(E[f(c)]) = 0
No help from risk analysis !!!!!
 Multiple Attribute
Decisions
 Frequently we care about multiple
attributes
 Cost
 Time

 Quality

 Relationship with owner

 Terminal nodes on decision trees can

capture these factors – but still need to
make different attributes comparable
 The bridge case - Multiple
tradeoffs
Computation of Pareto-Optimal Se
For decision D2

Replace
MTTF 10.0000
Cost 1.00

C3
MTTF 6.6667
Cost 0.30

C4
MTTF 5.7738
Cost 0.00
m: maximizing bridge duration, minimizing cost

MTTF = mean time to failure

 Pareto Optimality
 Even if we cannot directly weigh one attribute
vs. another, we can rank some consequences
 Can rule out decisions giving consequences
that are inferior with respect to all attributes
 We say that these decisions are “dominated by”
other decisions
 Key concept here: May not be able to identify
best decisions, but we can rule out obviously
bad
 A decision is “Pareto optimal” (or efficient
solution) if it is not dominated by any other
decision
 03/06/06 - Preliminaries
 Announcements
 Due dates Stellar Schedule and not Syllabus
 Term project
 Phase 2 due March 17th
 Phase 3 detailed description posted on Stellar, due May 11
 Assignment PS3 posted on Stellar – due date March
24
 Decision making under uncertainty
 Reading questions/comments?
 Utility and risk attitude
 You can manage construction risks
 Risk management and insurances - Recommended
 Decision Making Under
Risk
 Risk and Uncertainty
 Risk Preferences, Attitude and
Premiums
 Examples of simple decision trees

 Decision trees for analysis

 Flexibility and real options

 Multiple objective
The student’s dilemma
 Decision Making Under
Risk
 Risk and Uncertainty
 Risk Preferences, Attitude and
Premiums
 Examples of simple decision trees

 Decision trees for analysis

 Flexibility and real options

 Bidding
 What choices do we have?
 How does the chance of winning
vary with our bidding price?
 How does our profit vary with our
bidding price if we win?
Example Bidding
Decision Tree
Time
Bidding Decision Tree with
Stochastic Costs,
Competing Bids
Selecting Desired Electrical
Capacity
 Decision Tree Example:
Procurement Timing
 Decisions
 Choice of order time (Order early,
Order late)
 Events
 Arrival time (On time, early, late)
 Theft or damage (only if arrive early)

 Consequences: Cost
 Components: Delay cost, storage cost,
cost of reorder (including delay)
Procurement Tree
 Decision Making Under
Risk
 Risk and Uncertainty
 Risk Preferences, Attitude and
Premiums
 Decision trees for representing
uncertainty
 Decision trees for analysis

 Flexibility and real options

 Analysis Using Decision
Trees
 Decision trees are a powerful
analysis tool
 Example analytic techniques
 Strategy selection (Monte Carlo
simulation)
 One-way and multi-way sensitivity
analyses
 Value of information
Recall Competing Bid Tree
 Monte Carlo simulation
 Monte Carlo simulation randomly generates values for
uncertain variables over and over to simulate a model.
 It's used with the variables that have a known range of
values but an uncertain value for any particular time
or event.
 For each uncertain variable, you define the possible
values with a probability distribution.
 Distribution types include:

…
 A simulation calculates multiple scenarios of a model
by repeatedly sampling values from the probability
distributions
 Computer software tools can perform as many trials
(or scenarios) as you want and allow to select the
optimal strategy
Monetary Value of
$6.75M Bid
Monetary Value of $7M
Bid
With Risk Preferences:
6.75M
With Risk Preferences:
7M
Larger Uncertainties in
Cost
(Monetary Value)
Large Uncertainties II
(Monetary Values)
With Risk Preferences for
Large Uncertainties at
lower bid
With Risk Preferences for
Higher Bid
Optimal Strategy
 Decision Making Under
Risk
 Risk and Uncertainty
 Risk Preferences, Attitude and
Premiums
 Decision trees for representing
uncertainty
 Examples of simple decision trees

 Decision trees for analysis

 Flexibility and real options

 Flexibility and Real
Options
 Flexibility is providing additional
choices
 Flexibility typically has
 Value by acting as a way to lessen the
negative impacts of uncertainty
 Cost
 Delaying decision
 Extra time

 Cost to pay for extra “fat” to allow for

flexibility
 Ways to Ensure of
Flexibility
in Construction
 Alternative Delivery  Contingent plans for
Alternative Delivery
 Clear spanning (to  Value engineering
 Geotechnical conditions
allow movable walls)
 Procurement strategy
 Extra utility conduits  Additional elevator
(electricity, phone,  Larger electrical
…) panels
 Larger footings &  Property for expansion
columns  Sequential
 Broader foundation construction
 Alternative  Wiring to rooms
heating/electrical
 Adaptive Strategies
 An adaptive strategy is one that
changes the course of action based
on what is observed – i.e. one that
has flexibility
 Rather than planning statically up front,
explicitly plan to adapt as events unfold
 Typically we delay a decision into the
future
 Real Options
 Real Options theory provides a means of
estimating financial value of flexibility
 E.g. option to abandon a plant, expand bldg
 Key insight: NPV does not work well with
uncertain costs/revenues
 E.g. difficult to model option of abandoning
invest.
 Model events using stochastic diff.
equations
 Numerical or analytic solutions
 Can derive from decision-tree based framework
Example: Structural Form
Flexibility
 Considerations
 Tradeoffs
 Short-term speed and flexibility
 Overlapping design & construction and different
construction activities limits changes
 Short-term cost and flexibility
 E.g. value engineering away flexibility
 Selection of low bidder
 Late decisions can mean greater costs
 NB: both budget & schedule may ultimately be
better off w/greater flexibility!
 Frequently retrofitting $ > up-front $
 Decision Making Under
Risk
 Risk and Uncertainty
 Risk Preferences, Attitude and
Premiums
 Decision trees for representing
uncertainty
 Examples of simple decision trees

 Decision trees for analysis

 Flexibility and real options

 Readings
 Required
 More information:
 Utility and risk attitude – Stellar Readings
section
 Get prepared for next class:
 You can manage construction risks – Stellar
 On-line textbook, from 2.4 to 2.12

 Recommended:
 Meredith Textbook, Chapter 4 Prj
Organization
 Risk management and insurances – Stellar
 Risk - MIT libraries
 Haimes, Risk modeling, assessment, and management

 Mun, Applied risk analysis : moving beyond

uncertainty

 Flyvbjerg, Mega-projects and risk

 Chapman, Managing project risk and uncertainty : a

constructively simple approach to decision making

 Bedford, Probabilistic risk analysis: foundations and

methods

 … and a lot more!