What’s it all about?
Selecting between options.
Decision Trees are technique using a visual representation of options and probabilities to allow you to make the best choice.
Watch This
A good simple version to get the idea.
Wikipedia entry on Decision Trees.
https://en.wikipedia.org/wiki/Decision_treehttps
Problems with the Decision Tree.
It is important to realise a number of points before relying on a Decision Tree to make an important decision.
- You are only going to do it once.
- The probabilities given are guesses.
- You will not get the EV.
- The highest EV is not necessarily the best.
- Numbers encourage possibly unjustified confidence.
1. The EV is calculated using probabilities, you are essentially working out the average outcome as if you did this 100 times. However, you are only going to do it once.
2. The probabilities you are using are not absolutes, they are ‘best guesses’. Sometimes we may have spent a lot of time and money determining the probabilities, but they are still ‘best guesses’. Probablities are not absolutes.
3. Because you are only doing it once, you will get one of the actual numbers you calculated, not the EV. That actual number can be less than the EV (the EV is a weighted average).
4. We normally select on the basis of the highest EV. You won’t get the EV though. The probability of a high reward in the chosen option may be less than the probability of high reward in the other(s). You need to take into account your attitude to risk before making the final decision.
5. Because we can calculate absolute numbers to any number of decimal places we want we can have confidence in our decision which isn’t warranted. We have to bear in mind points 1-4 so as not to make a mistake through over-confidence.
Read this.
https://en.wikipedia.org/wiki/Decision_tree
https://www.investopedia.com/articles/financial-theory/11/decisions-trees-finance.asp
Possible Written Questions.
(No indication of marks – the more marks a question gets, the more you are expected to write – detail that is, not just words!) If you can’t answer these, you need to do some more reading. I do ‘find’ questions elsewhere, so these aren’t all questions I have used myself.
Mostly questions will be calculations, but the calculation normally ends up with you recommending a specific option. Typically this will be the option with the highest EV (Expected Value). Watch out though. Sometimes the option with the highest EV will have a high percentage chance of failure. You should take this into account. The EVs are simplistically what you would expect to earn on average if you did it 100 times. The reality is that usually you will only do it once!
Outline the limitations of using Decision Trees for selecting between options.
Comment on whether Expected Value is the most appropriate way of selecting between options.