Most investments or projects fail to see the light of the day because of the fact management has either failed to incorporate risk into the investment appraisal process or has wrongly interpreted the signals coming from risk measurement and assessment tools.
This article is not written to reteach these investment appraisal risk management tools but to give you something to think about while applying them in your day to day management functions.
Expected Value and Decision Tree
Expected values and decision tree are two investment appraisal risk management tools that are used by managers who are indifferent to risk.
Probabilities are used to weight possible outcomes of different events. The aim of this exercise is to smooth out the effects of factors that are seasonal in nature.
Expected values and decision trees have been around for a long time and have been used in varying degrees and forms. The main idea behind the use of expected values is that long run averages of repetitive events are pulled together and this averages out eventually- and this is its main weakness.
In real life, events cannot repeatedly happen on same level and frequency over the long run. The other basic assumption is that the law of large numbers will at a point force the outcome of series of events towards the expected value.
Well, this may be true in statistics and other modelling discipline but not very practicable at least in the now economy that we all live in.
In as much as many financial decisions are made based on the result of risk management tools like expected values and decision tree, care should be taken so as not to be caught unaware.
Major Investment Appraisal Risk Management Strategy
The idea here is to go all out and maximize any possible returns not minding the consequential implication of any bad thing that might happen.
Managers who assess investment risk in this manner are usually those with huge appetite for risk. Many entrepreneurs are within this class. There is a saying my native Igbo language that says ‘’if you must eat a toad, eat a matured toad so that you can proudly answer when someone calls you a toad eater’’
In simple term, you are required to select an alternative that maximizes the highest possible outcome. A payoff table is prepared to outline the possible outcome of decision choice under different scenarios.
Would you rather hope for the best and risk it all?
The maximin is the opposite of the maximax decision rule. Here, the rule is to select the option that maximizes payoff amongst the list of minimum alternatives. The manager basically assembles the worst outcome and then selects the best of the worst.
This is what many management theorists often call the pessimist approach to investment appraisal. Managers that favour this approach are risk averse that assume the worst will happen and then take measures to brace against it.
Would you rather settle for the best of the worst and be safe or go for the best thereby exposing you to potential loss?
Minimax regret is a strategy that seek to minimize what would be lost if the wrong decision was to be made. Just like the expected value decision making criteria, this approach appeals to people that don’t really care about risk
In its simplest form, sensitivity analysis is a calculated ‘what if analysis. It is basically question and answer session that involves playing with numbers. I have written an article that fully explains what a sensitivity analysis is. A classic use of sensitivity analysis in investment appraisal is finding the effect of increase in operational cost on the NPV of a project.
There are other advanced techniques like game theory, advanced simulation, simplex method linear programming. These advanced investment appraisal risk management tools will not be discussed in this article but I will be writing post on each of them shortly so do come back for more.
The real worth of investment is in its safety. The tools and strategies that are discussed in this write are all aimed at one objective- to preserve the assets of the company including its investments.
Bye for now.