Risk and Uncertainty in Managerial Decision Making

Risk means a low probability of an expected outcome. From business decision-making point of view, risk refers to a situation in which a business decision is expected to yield more than one outcome and the probability of each outcome is known to the decision-makers or it can be reliably estimated. For example, if a company doubles its advertisement expenditure, there are four probable outcomes such as; (i) its
sales may more-than-double, (ii) they may just double, (iii) increase in sales may be less than double and (iv) sales do not increase at all.

The company has the knowledge of these probabilities or has estimated the probabilities of the four outcomes on the basis of its past experience as: (i) more-than double – 20 percent (or 0.2), (ii) almost double – 40 percent (or 0.4), (iii) less than double – 50 percent (or 0.5) and (iv) no increase – 10 percent (or 0.1).

It means that there is 80 percent risk in expecting more than doubling of sales, and 60 percent risk in expecting doubling of sale, and so on.

There are two approaches to estimating probabilities of outcomes of a business decision, viz. (i) a priori approach, i.e., the approach based on deductive logic or intuition and (ii) posteriori approach, i.e., estimating the probability statistically on the basis of the past data. In case of a priori probability, we know that when a coin is tossed, the probabilities of ‘head’ or ‘tail’ are 50:50, and when a dice is thrown, each side has 1/6 chance to be on the top. The posteriori assumes that the probability of an event in the past will hold in future also. The probability of outcomes of a decision can be estimated statistically by way of ‘standard deviation’ and ‘coefficient of variation’.

Uncertainty refers to a situation in which there is more than one outcome of a business decision and the probability of no outcome is known nor can it be meaningfully estimated. The unpredictability of outcome may be due to lack of reliable market information, inadequate past experience and high volatility of the market conditions. For example, if a Nepalese firm, highly concerned with population burden on the country, invents an irreversible sterility drug, the outcome regarding its success is completely unpredictable. Consider the case of insurance companies. It is possible for them to predict fairly accurately the probability of death rate of insured people, accident rate of cars and other automobiles, rate of buildings catching fire, and so on, but it is not possible to predict the death of a particular insured individual, a particular car meeting an accident or a particular house catching fire, etc.

The long-term investment decisions involve a great deal of uncertainty with unpredictable outcomes. But, in reality, investment decisions involving uncertainty have to be taken on the basis of whatever information can be collected, generated and ‘guesstimated’. For the purpose of decision-making, the uncertainty is classified as: (a) complete ignorance and (b) partial ignorance.

In case of complete ignorance, investment decisions are taken by the investor using their own judgment or using any of the rational criteria. What criterion he chooses depends on his attitude towards risk. The investor’s attitude towards risk may be that of: (i) a risk averter, (ii) a risk neutral or (iii) a risk seeker or risk lover.

In simple words, a risk averter avoids investment in high-risk business. A risk-neutral investor takes the best possible decision on the basis of his judgment, understanding of the situation and his past experience. He does his best and leaves the rest to the market. A risk lover is one who goes by the dictum that ‘the higher the risk, the higher the gain’. Unlike other categories of
investors, he prefers investment in risky business with high expected gains.

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