Measuring Risk and Uncertainty Article

Written by Drew Coles, member of the chartered institute of Management Accountants.

Measuring risk and uncertainty is an important part of business and project management. To be able to quantify and express the risk involved in investments we can get a better idea of the viability of a project or investment. The simplest definition of risk is that it is the variability of possible returns. For example, we cannot predict future sales with certainty.
Ultimately risk is the possibility the result will not be as expected There can be upside and downside risk. Uncertainty is risk that cannot be measured by the business

Models to measure risk and uncertainty

There are several models to measure risk which we will go through in more detail below. It is important to understand that these models work within other financial models to measure return such as Net Present Value.

Sensitivity Analysis

Sensitivity analysis looks at varying key estimates to see how much safety margin we have before the decision we are making will change. For example, based on a selling price of £5 a project is worthwhile but if it drops by more than 10% to below £4.50, then the project should be rejected. Ultimately Sensitivity analysis is used to understand how changes to the inputs in a financial model will affect the result. It will allow the company to see which inputs are very sensitive to change for instance inputs with safety margins under 10% are very sensitive to the project and should be reviewed before a decision is finalised.

Payback

Payback is a straightforward model devised to understand how long it would take for a company to reclaim all money initially invested into a project. It is generally accepted the longer it takes to get back the initial investment the more risk the investment will be therefore shorter payback periods are more attractive to the investor.

Expected values

Expected Value or EV for short are an easy and handy way of incorporating risk and uncertainty into investment appraisals. It works by finding the maximum and minimum income possible in an investment and using weighted average produces a final figure to be used. This income figure will then be used in the appraisal and has the benefit of incorporating upside and downside risk. The drawbacks of EV is the figures used the calculations are very subjective.

Pay off tables

A profit table (payoff table) can be a useful way to represent and analyse a scenario where there is a range of possible outcomes and a variety of possible responses. A payoff table simply illustrates all possible profits/losses and as such is often used in decision making under uncertainty. The payoff table uses contribution for figures (sales income minus direct costs) This helps the business understand what the most optimum output would depending on demand. See example below

Risk Attitude

When evaluating risk, the business must understand what its attitude is for example the following groups represent an approach to risk.
The maximax rule for an optimist - i.e. someone who wants the best possible upside potential without being very concerned about possible losses or downside.
The maximin rule for a pessimist looking to minimise his losses - i.e. someone who wants to minimise the potential downside exposure.
The minimax regret rule is for someone who doesn't like making the wrong decision. This approach seeks to minimise such "regret".
The approaches above are normally used in conjunction with payoff tables and are a great way to analyse the company’s approach to risk and to target the projects which fit the companies risk profile.

Other ways to evaluate risk

The methods above try to quantify risk using mathematical approaches but the following methods use qualitative techniques to evaluate risk:

Focus groups

Focus groups are a common market research tool involving small groups (typically eight to ten people) selected from the broader population. The group is interviewed through facilitator-led discussions in an informal environment in order to gather their opinions and reactions to a particular subject.

Measurement research

The objective here is to build on the motivation research by trying to quantify the issues involved.
Sample surveys are used to find out how many people buy the product, what quantity each type of buyer purchases, and where and when the product is bought.
This sort of information can also be collected in retail environments at the point of sale, for example, through the use of loyalty cards.

Simulation

Simulation is a computer based method where random numbers are used to generate different possible scenarios, which can then be solved. The process is re-run many times to then get an idea of the spread of possible outcomes.

Summary

In summary a number of these methods can be used in conjunction with financial models and together in order for an organisation to produce a detailed account of the risk involved in an investment. Results from the methods above should be displayed in a concise understandable manner in order to help decision makers.

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