Assessing Risk Tolerance for Decision Making

In this article, we will continuously go through Mr K's decision making process in Example 4 in <Decision Tree> by examining his risk tolerance.

Risk Tolerance

Risk tolerance is the willingness of a person to take risk for better consequences. It means how the person weigh the downside of the consequences as compared to the upside, i.e. how significance of the downside of the consequences he would be impacted? 

Most risk averse people will weigh the downside (loss) heavier than the upside (gains), even the probability for both sides are equal. 

Risk tolerance is a crucial factor to determine the diversification of an asset portfolio, which also is an attribute to tradeoff of risk/return. So, understanding the role of risk tolerance is important not only for making daily decisions but also beneficial for making investment decisions.

 

Back to Example 4:

Background: Refer to Example 4 in  <Decision Tree>

Even though Mr K has a high chance to win the legal trial, there is still possibility to lose and end up losing more money than he had lost in the business conflict. In this case, he should assess his own risk tolerance in putting the lawsuit forward. 

So, to sue? or not to sue?

Table 1. Summary of the consequences in taking and not taking legal action.

There is 100% chance of getting $600k as a net gain if Mr K is willing to settle the case. If I were him, I would start from examining my objectives (criteria) and assess my risk tolerance in the whole situation by running through scenario analysis. I will ask myself the following questions:

 

What actually were my objectives in taking this lawsuit?

1. Find justice
2. Get reasonable compensation for my loss of $400,000 and my reputation hurt (converted to $100,000 loss)
   

Think about if not taking legal action:

1. Is the money offered by my business partner ($600k) enough to compensate for my loss (-$400k), including the time and energy I had experienced?
2. Is accepting his offer better than taking legal action, given the above objectives are satisfied? i.e. (i) The money gained from not taking legal action is more than taking action and that can compensate my financial loss on top of my reputation hurt; and (ii) justice is seen to be done.
   

 

Think about if taking legal action:

There are 3 main considerations if I have to take legal action, the net gain should:

• be able to cover my financial loss in business conflict (-$400k) & reputation hurt (-$100k): This is the primary objective and bottom line to fulfill. 
  
• be able to cover my time sacrifice and emotional energy input for litigation
• be able to get more money than the compensation gain ($600k) by settling outside court
  

 

Questions I will ask myself: 

1) There is 50% chance (25% + 25%) of  the money awarded (net gain: $175k or $425k), if wins (75%), is less than the compensation offered by my business partner ($600k), am I willing to accept the outcome? 

• Answer: This reveals that there is 37.5%  (= 75%  × 25% +  75%  × 25%) chance, together with the 25% lose, that means there is 62.5% chance that my reward is less than the 'risk-free' $600k compensation. For me, I will not accept this outcome.

2) There is 75%  × 25% chance (=18.75%) of getting the money award (net gain: $175k) less than the money I lost in the business conflict (-$400k) and reputation hurt (-$100k), if it really is the case, am I willing to accept that?

• Answer: Same as Q1. But now, compares with my loss. This reveals that there is 37.5%  (= 75%  × 25% +  75%  × 25%) chance that my primary objective and bottom line cannot be fulfilled if I put the case to court. In another word, there is 62.5% chance to meet my primary objective and bottom line. 

 

3) What if I only get the minimum money rewarded ($175k)? Is this sufficient to compensate for my loss of emotional energy and time spent in the lawsuit, on top of my loss in business conflict (-$400k) and reputation hurt (-$100k)?

•  Answer: Definitely not. It cannot even satisfy the need to cover my financial loss (-$400k), let alone the compensation for my reputation hurt (-$100k), emotional energy and time consumption.

 

4) Imagine what is like to lose the law case? Can I bear this consequence of losing the compensation offered by my business partner and paying a huge sum of money for legals (-$450k), emotional burden and time spent, on top of my loss in business conflict (-$400k) and the reputation hurt (-$100k)? Also, it will very likely further hurt my reputation for shifting responsibility, would I still be willing to take the chance despite all the adverse consequences at an estimated low chance of losing?

• Answer: There is 25% chance of losing $995k [-($450k + $400k + $100k + emotional energy loss (WTP: $25k) + time sacrifice (WTP: $20k)]. Even though the chance of losing seems relatively low (1/4), I personally don't want to bet on it, because the price of losing is so high that I cannot pay.

 

5) Am I willing to give up the chance of getting the money he offered instantly for sure without further hassles to get into a rather lengthy and torturing legal process which is estimated to have a high chance to win? 

         It is hard to think this way, rather we should use trade-off mindset to tackle the problem, ask:

• How much more money would I be willing to accept so as to get myself into the law proceedings in order to gain the extra money than the compensation $600k received by settling the case?
  
• Or, is the extra more money I get, on top of the $600k compensation, sufficient to compensate my emotional energy and time I need to put in the litigation? 

• To answer this question, we should calculate what extra money can we possibly get on top of the $600k compensation:
• Calculate: the total expected value of awarding extra money than the $600k compensation:
• Since only net gains of $675k and $925k can be more than $600k, we just use these two awards for the calculation:

Total expected value of awarding extra money = 75% × 25% × ($675k - $600k) + 75% × 25% × ($925k - $600k) = $75k

 

Now, the question thus is:  

• Can the additional $75k, on top of $600k, enough to compensate for my loss of emotional energy and time to undertake the legal process?

             Here, the answer to this question can be different for different people depending on risk appetite.

Risk Appetite

A risk averse person will choose not to take legal action, whereas a risk seeking person will bank on taking legal action in order to bet on a larger sum of money award ($1.375m, net gain $925k, which is $325k more than the compensation ($600k) for settling outside court). 

• A risk seeking person will think that it is worth to gamble for a higher return, because they may think that the loss is a sunk cost, they have already been in a loss situation, they would rather bet on a larger reward than just seeking compensation at the expense of a rather high legal fees $450k. 
• Their mindset would be using the legal fees (450k), emotional energy WTP ($25k) and time spent ($20k) as a cost to bet the rewards range from $625k to $1.375m at 75% chance. Otherwise 25% get zero award and lose all the cost. 
• Their eyes will bank on the highest reward. That said, maximise the chance for positive return and minimise the chance of losing.
• For a risk averse person, like most people do, would look for a compensation that is sufficient to cover the loss of $500k (financial loss $400k + reputation hurt $100k) and happy to gain $100k as an extra money at a $600k compensation for settling the case outside court. 

Anyway when you run through all possible outcomes and force yourself to experience the imaginary legal process, you will/ may have your answer as to which option to choose. This is entirely a personal choice!  

The process can examine if you are able or willing to take the emotional burden, or willing to take the risk of losing.

 

A Quick Fix

If after all analyses you have done and you still can't make a choice, one simple guideline I think you can consider to do is: to check how many questions/concerns you have for the options. The more questions you have for yourself, the more worries/ concern/ emotional burden you have for that option, that means you somewhat would want yourself to avoid that option. At this point, after all analyses, you still have those worries you cannot clear out. Apparently there is no clear pros on one side over the other. Unless you can find a factual support to clear that out, you should pick the option with less concern/ worries.

As above, you can see, I got more questions/ concerns for taking legal action, that means deep down, I tend to choose "not to take legal action". The questions I raised to myself are for trying to convince/ persuade myself not to take that option. There is no fact to support the otherwise is better. Intuitively I feel more comfortable to choose the option of "not to take legal action". 

On contrary, if I am a risk seeking person, I probably would expand the benefit of taking legal action for betting the highest monetary award and might at the same time minimise the drawbacks of losing and awarding with less money than that could be able to cover my financial loss, legal fee, emotional energy and further reputation loss etc.

So a simple and quick way to do is choose the option which I raised fewer questions and that makes me more comfortable and securer. Look, the choice is very personal, no right or wrong, as long as you are willing to bear the consequences.

To sum up, for the case in Example 4, if I were Mr K, I will choose not to take legal action and happy with getting the compensation of $600k from my business partner. Because to me, this sum of money can compensate my financial loss and reputation hurt (- $400k + -$100k) and can save my time and emotional energy from undergoing a lengthy legal trial. Also it protects from taking the risk of awarding the lowest range of money and further harm my reputation. This reasoning is sufficient for me to trade off the highest monetary award, thus I will settle the case outside the court.

How much should offer as a compensation?

If you were the business partner being sued, how much should you offer as a compensation? The beauty of setting the money compensation in this case is the amount of money is not only higher than all the loss, but also produce some extra money. 

Just imagine: Say, if the money compensation the business partner can offer is just $500k, then the chance of settling the case would substantially reduce. 

If the compensation is further reduced to $400k, then apparently, even the most risk averse people would take legal actions. Since the compensation is not sufficiently covering the loss, this makes the loss situation even obvious for them which pushes people to take risk seeking action. In another word, you are indirectly encouraging people to sue you. 

So if you are to offer a compensation, try to calculate the amount of money with some margin above the money loss of the counterpart. This will raise your success rate. 

On the contrary, if you calculate the chance of your winning the court case is higher than the counterpart, you should not give any compensation. This will force your counterpart to consider a high price for taking legal action at the expense of further financial loss and emotional torture to gamble at a low winning chance. 

Conclusion

After the decision tree is drawn, incorporating all the costs and key uncertainties, we should also assess risk tolerance by scenario analysis, and making use of trade-off concept, to assess our own risk tolerance (willingness to take risk to bet on better consequences). 

Caveats are that: (1) the equal probability distribution is assumed for the 4 ranges of money awards, actually there is no way to accurately forecast, that means the calculated outcome should not be treated as an absolute answer. (2) the WTP for emotional energy and time consumed for different money awards at win situation and lose situation should be different. For simplicity, I just put equal WTP at all levels. These are the variables you should consider before making any decision or taking any action.

In fact, there is no one absolute correct answer when it comes to decision making. In daily events, people choose differently, not only because of human biases and heuristics, but also because of our different risk tolerance. There is no perfect decision that fits all people.

For better or worse, what we can do is do whatever we can to ensure the decision fits our objectives and needs, there is no guarantee that it is going to work out fine because the outcome will subject to uncertainty.

Perhaps, we can also use the satisfier's mindset, rather than a maximiser's mindset, to make a "good-enough" decision. As long as we can satisfy our needs/objectives/criteria, that is already good enough, there is no need to achieve the best for everything. I am happy with this "good enough" mindset and be a satisfier.

PS: Another article about quantification of risk tolerance using the concept of trade-off is in <可量化的風險承受程度 (Quantifiable Risk Tolerance)>. 

 

More Topics:

Smart Choices (1) | Focus and Defining Problem

Smart Choices (2) | Eight Elements in PrOACT Approach

Smart Choices (3) | Comparing with Consequence Table

Trade-offs in Decision Making

Uncertainty and Chance

Decision Tree

Subjective Probability Estimation

可量化的風險承受程度 (Quantifiable Risk Tolerance)

Reference

John S. Hammond, Ralph L. Keeney, Howard Raiffa, Smart Choices - A Practical Guide to Making Better Life Decisions, Broadway Books, 1999.

 

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