1.040/1.

401
Project Management
Spring 2006

Risk Analysis
Decision making under risk and uncertainty

Department of Civil and Environmental Engineering

Massachusetts Institute of Technology
 Preliminaries
 Announcements
 Remainder
 email Sharon Lin the team info by midnight, tonight
 Monday Feb 27 - Student Experience Presentation
 Wed March 1st – Assignment 2 due
 Today, recitation Joe Gifun, MIT facility
 Next Friday, March 3rd, Tour PDSI construction site
 1st group noon – 1:30
 2nd group 1:30 – 3:00
 Construction nightmares discussion
 16 - Psi Creativity Center, Design and Bidding phases
 Project Management Phase

FEASIBILITY DESIGN DEVELOPMENT CLOSEOUT OPERATIONS

PLANNING

Financing&Evaluation

Risk Analysis&Attitude
 Risk Management Phase

FEASIBILITY DESIGN DEVELOPMENT CLOSEOUT OPERATIONS

PLANNING

RISK MNG

 Risk management (guest seminar 1st wk April)

 Assessment, tracking and control
 Tools:
 Risk Hierarchical modeling: Risk breakdown structures
 Risk matrixes
 Contingency plan: preventive measures, corrective actions, risk budget,
etc.
 Decision Making Under Risk
Outline
 Risk and Uncertainty
 Risk Preferences, Attitude and Premiums
 Examples of simple decision trees
 Decision trees for analysis
 Flexibility and real options
Decision making
 Uncertainty and Risk
 “risk” as uncertainty about a consequence
 Preliminary questions
 What sort of risks are there and who bears them in
project management?
 What practical ways do people use to cope with
these risks?
 Why is it that some people are willing to take on
risks that others shun?
 Some Risks
 Weather changes
 Different productivity
 (Sub)contractors are
 Unreliable
 Lack capacity to do work
 Lack availability to do work
 Unscrupulous
 Financially unstable
 Late materials delivery
 Lawsuits
 Labor difficulties
 Unexpected manufacturing
costs
 Failure to find sufficient
tenants
 Community opposition
 Infighting & acrimonious
relationships
 Unrealistically low bid
 Late-stage design changes
 Unexpected subsurface
conditions
 Soil type
 Groundwater
 Unexpected Obstacles
 Settlement of adjacent
structures
 High lifecycle costs
 Permitting problems
 …
 Importance of Risk
 Much time in construction management is spent
focusing on risks
 Many practices in construction are driven by risk
 Bonding requirements
 Insurance
 Licensing
 Contract structure
 General conditions
 Payment Terms
 Delivery Method
 Selection mechanism
 Outline
 Risk and Uncertainty
 Risk Preferences, Attitude and Premiums

 Examples of simple decision trees

 Decision trees for analysis

 Flexibility and real options

 Decision making under risk
Available Techniques
 Decision modeling
 Decision making under uncertainty
 Tool: Decision tree

 Strategic thinking and problem solving:

 Dynamic modeling (end of course)
 Fault trees
 Introduction to Decision Trees
 We will use decision trees both for
 Illustrating decision making with uncertainty
 Quantitative reasoning

 Represent
 Flow of time
 Decisions

 Uncertainties (via events)

 Consequences (deterministic or stochastic)

 Decision Tree Nodes
Time

 Decision (choice) Node

 Chance (event) Node

 Terminal (consequence) node

 Outcome (cost or benefit)
 Risk Preference
 People are not indifferent to uncertainty
 Lack of indifference from uncertainty arises from
uneven preferences for different outcomes
 E.g. someone may
 dislike losing $x far more than gaining $x
 value gaining $x far more than they disvalue losing $x.

 Individuals differ in comfort with uncertainty

based on circumstances and preferences
 Risk averse individuals will pay “risk premiums”
to avoid uncertainty
 Risk preference
 The preference depends on decision maker point of view
 Categories of Risk Attitudes
 Risk attitude is a general way of classifying risk
preferences
 Classifications
 Risk averse fear loss and seek sureness
 Risk neutral are indifferent to uncertainty
 Risk lovers hope to “win big” and don’t mind losing
as much
 Risk attitudes change over
 Time
 Circumstance
 Decision Rules
 The pessimistic rule (maximin = minimax)
 The conservative decisionmaker seeks to:
 maximize the minimum gain (if outcome = payoff)
 or minimize the maximum loss (if outcome = loss, risk)
 The optimistic rule (maximax)
 The risklover seeks to maximize the maximum gain
 Compromise (the Hurwitz rule):
 Max (α min + (1- α) max) , 0 ≤ α ≤ 1
 α = 1 pessimistic
 α = 0.5 neutral
 α = 0 optimistic
The bridge case – unknown prob’ties
$ 1.09 million
replace

$1.61 M

repair
$0.55 Investment PV

$1.43
•Pessimistic rule
• min (1, 1.61) = 1 replace the bridge
•The optimistic rule (maximax)
• max (1, 0.55) = 0.55 repair … and hope it works!
 The bridge case – known prob’ties
$ 1.09 million
replace

0.25 $1.61 M

repair 0.5
$0.55 Investment PV
0.25
$1.43

Expected monetary value

E = (0.25)(1.61) + (0.5)(0.55) + (0.25)(1.43) = $ 1.04 M

Data link
 The bridge case – decision
 The pessimistic rule (maximin = minimax)
 Min (Ei) = Min (1.09 , 1.04) = $ 1.04 repair
 In this case = optimistic rule (maximax)
 Awareness of probabilities change risk
attitude
 Other criteria
 Most likely value
 For each policy option we select the outcome with
the highest probability
 Expected value of Opportunity Loss
 To buy soon or to buy later
-100
Buy soon

Buy later -100-30+5 = -125

-100+5 = -95

-100+5+30 = -65

Current price = 100

S1 = + 30%
S2 = no price variation
S3 = - 30%

Actualization = 5
To buy soon or to buy later
-100
Buy soon

Buy later -125

0. 5
0.25
-95
0.25
-65
 The Utility Theory
 When individuals are faced with uncertainty they make
choices as is they are maximizing a given criterion: the
expected utility.

 Expected utility is a measure of the individual's implicit

preference, for each policy in the risk environment.

 It is represented by a numerical value associated with

each monetary gain or loss in order to indicate the
utility of these monetary values to the decision-maker.
 Adding a Preference function

1.35

1
.7

125 100 65
Expected (mean) value
E = (0.5)(125) + (0.25)(95) + (0.25)(65) = -102.5
Utility value:
f(E) = ∑ Pa * f(a) = 0.5 f(125) + 0.25 f(95) + .25 f(65) =
= .5*0.7 + .25*1.05 + .25*1.35 = ~0.95
Certainty value = -102.5*0.975 = -97.38
Defining the Preference Function
 Suppose to be awarded a $100M contract price
 Early estimated cost $70M
 What is the preference function of cost?
 Preference means utility or satisfaction
utility

70 $
 Notion of a Risk Premium
 A risk premium is the amount paid by a (risk
averse) individual to avoid risk
 Risk premiums are very common – what are
some examples?
 Insurance premiums
 Higher fees paid by owner to reputable contractors

 Higher charges by contractor for risky work

 Lower returns from less risky investments

 Money paid to ensure flexibility as guard against risk

Conclusion: To buy or not to buy
 The risk averter buys a “future” contract that
allow to buy at $ 97.38
 The trading company (risk lover) will take
advantage/disadvantage of future benefit/loss
 Certainty Equivalent Example
 Consider a risk averse individual with
preference fn f faced with an investment c
that provides Mean satisfaction with
investment
.50
 50% chance of earning $20000
.25
 50% chance of earning $0
Certainty equivalen
 Average money from investment = of investment

 .5*$20,000+.5*$0=$10000
 Average satisfaction with the investment= Mean value
Of investme
 .5*f($20,000)+.5*f($0)=.25
 This individual would be willing to trade for a

$5000
sure investment yielding satisfaction>.25
instead
 Can get .25 satisfaction for a sure f-1(.25)=$5000
 We call this the certainty equivalent to the investment
 Therefore this person should be willing to trade
this investment for a sure amount of
money>$5000
Example Cont’d (Risk Premium)
 The risk averse individual would be willing to
trade the uncertain investment c for any certain
return which is > $5000
 Equivalently, the risk averse individual would be
willing to pay another party an amount r up to
$5000 =$10000-$5000 for other less risk averse
party to guarantee $10,000
 Assuming the other party is not risk averse, that
party wins because gain r on average
 The risk averse individual wins b/c more satisfied
 Certainty Equivalent
 More generally, consider situation in which have
 Uncertainty with respect to consequence c
 Non-linear preference function f
 Note: E[X] is the mean (expected value) operator
 The mean outcome of uncertain investment c is E[c]
 In example, this was .5*$20,000+.5*$0=$10,000
 The mean satisfaction with the investment is E[f(c)]
 In example, this was .5*f($20,000)+.5*f($0)=.25
 We call f-1(E[f(c)]) the certainty equivalent of c
 Size of sure return that would give the same satisfaction as c
 In example, was f-1(.25)=f-1(.5*20,000+.5*0)=$5,000
 Risk Attitude Redux
 The shapes of the preference functions means
can classify risk attitude by comparing the
certainty equivalent and expected value
 For risk loving individuals, f-1(E[f(c)])>E[c]
 They want Certainty equivalent > mean outcome
 For risk neutral individuals, f-1(E[f(c)])=E[c]
 For risk averse individuals, f-1(E[f(c)])<E[c]
 Motivations for a Risk Premium
 Consider
 Risk averse individual A for whom f-1(E[f(c)])<E[c]
 Less risk averse party B

 A can lessen the effects of risk by paying a risk

premium r of up to E[c]-f-1(E[f(c)]) to B in
return for a guarantee of E[c] income
 The risk premium shifts the risk to B
 The net investment gain for A is E[c]-r, but A is
more satisfied because E[c] – r > f-1(E[f(c)])
 B gets average monetary gain of r
 Gamble or not to Gamble

EMV
(0.5)(-1) + (0.5)(1) = 0

Preference function f(-1)=0, f(1)=100

Certainty eq. f-1(E[f(c)]) = 0
No help from risk analysis !!!!!
 Multiple Attribute Decisions
 Frequently we care about multiple attributes
 Cost
 Time

 Quality

 Relationship with owner

 Terminal nodes on decision trees can capture

these factors – but still need to make different
attributes comparable
 The bridge case - Multiple tradeoffs
Computation of Pareto-Optimal Set
For decision D2

Replace
MTTF 10.0000
Cost 1.00

C3
MTTF 6.6667
Cost 0.30

C4
MTTF 5.7738
Cost 0.00
Aim: maximizing bridge duration, minimizing cost

MTTF = mean time to failure

 Pareto Optimality
 Even if we cannot directly weigh one attribute vs.
another, we can rank some consequences
 Can rule out decisions giving consequences that are
inferior with respect to all attributes
 We say that these decisions are “dominated by” other
decisions
 Key concept here: May not be able to identify best
decisions, but we can rule out obviously bad
 A decision is “Pareto optimal” (or efficient solution) if
it is not dominated by any other decision
 03/06/06 - Preliminaries
 Announcements
 Due dates Stellar Schedule and not Syllabus
 Term project
 Phase 2 due March 17th
 Phase 3 detailed description posted on Stellar, due May 11
 Assignment PS3 posted on Stellar – due date March 24
 Decision making under uncertainty
 Reading questions/comments?
 Utility and risk attitude
 You can manage construction risks
 Risk management and insurances - Recommended
 Decision Making Under Risk
 Risk and Uncertainty
 Risk Preferences, Attitude and Premiums

 Examples of simple decision trees

 Decision trees for analysis

 Flexibility and real options

 Multiple objective
The student’s dilemma
 Decision Making Under Risk
 Risk and Uncertainty
 Risk Preferences, Attitude and Premiums

 Examples of simple decision trees

 Decision trees for analysis

 Flexibility and real options

 Bidding
 What choices do we have?
 How does the chance of winning vary with our
bidding price?
 How does our profit vary with our bidding price
if we win?
Example Bidding Decision Tree
Time
 Bidding Decision Tree with
Stochastic Costs, Competing Bids
Selecting Desired Electrical Capacity
 Decision Tree Example:
Procurement Timing
 Decisions
 Choice of order time (Order early, Order late)
 Events
 Arrival time (On time, early, late)
 Theft or damage (only if arrive early)

 Consequences: Cost
 Components: Delay cost, storage cost, cost of
reorder (including delay)
Procurement Tree
 Decision Making Under Risk
 Risk and Uncertainty
 Risk Preferences, Attitude and Premiums

 Decision trees for representing uncertainty

 Decision trees for analysis

 Flexibility and real options

 Analysis Using Decision Trees
 Decision trees are a powerful analysis tool
 Example analytic techniques
 Strategy selection (Monte Carlo simulation)
 One-way and multi-way sensitivity analyses

 Value of information
Recall Competing Bid Tree
 Monte Carlo simulation
 Monte Carlo simulation randomly generates values for uncertain
variables over and over to simulate a model.
 It's used with the variables that have a known range of values
but an uncertain value for any particular time or event.
 For each uncertain variable, you define the possible values with a
probability distribution.
 Distribution types include:

…
 A simulation calculates multiple scenarios of a model by
repeatedly sampling values from the probability distributions
 Computer software tools can perform as many trials (or
scenarios) as you want and allow to select the optimal strategy
Monetary Value of $6.75M Bid
Monetary Value of $7M Bid
With Risk Preferences: 6.75M
With Risk Preferences: 7M
Larger Uncertainties in Cost
(Monetary Value)
Large Uncertainties II
(Monetary Values)
With Risk Preferences for Large
Uncertainties at lower bid
With Risk Preferences for
Higher Bid
Optimal Strategy
 Decision Making Under Risk
 Risk and Uncertainty
 Risk Preferences, Attitude and Premiums

 Decision trees for representing uncertainty

 Examples of simple decision trees

 Decision trees for analysis

 Flexibility and real options

 Flexibility and Real Options
 Flexibility is providing additional choices
 Flexibility typically has
 Value by acting as a way to lessen the negative
impacts of uncertainty
 Cost
 Delaying decision
 Extra time

 Cost to pay for extra “fat” to allow for flexibility

 Ways to Ensure of Flexibility
in Construction
 Alternative Delivery
 Clear spanning (to allow
movable walls)
 Extra utility conduits
(electricity, phone,…)
 Larger footings &
columns
 Broader foundation
 Alternative
heating/electrical
 Contingent plans for
 Value engineering
 Geotechnical conditions
 Procurement strategy
 Additional elevator
 Larger electrical panels
 Property for expansion
 Sequential construction
 Wiring to rooms
 Adaptive Strategies
 An adaptive strategy is one that changes the
course of action based on what is observed – i.e.
one that has flexibility
 Rather than planning statically up front, explicitly
plan to adapt as events unfold
 Typically we delay a decision into the future
 Real Options
 Real Options theory provides a means of
estimating financial value of flexibility
 E.g. option to abandon a plant, expand bldg
 Key insight: NPV does not work well with
uncertain costs/revenues
 E.g. difficult to model option of abandoning invest.
 Model events using stochastic diff. equations
 Numerical or analytic solutions
 Can derive from decision-tree based framework
Example: Structural Form
Flexibility
 Considerations
 Tradeoffs
 Short-term speed and flexibility
 Overlapping design & construction and different construction
activities limits changes
 Short-term cost and flexibility
 E.g. value engineering away flexibility
 Selection of low bidder
 Late decisions can mean greater costs
 NB: both budget & schedule may ultimately be better off
w/greater flexibility!
 Frequently retrofitting $ > up-front $
 Decision Making Under Risk
 Risk and Uncertainty
 Risk Preferences, Attitude and Premiums

 Decision trees for representing uncertainty

 Examples of simple decision trees

 Decision trees for analysis

 Flexibility and real options

 Readings
 Required
 More information:
 Utility and risk attitude – Stellar Readings section
 Get prepared for next class:
 You can manage construction risks – Stellar
 On-line textbook, from 2.4 to 2.12

 Recommended:
 Meredith Textbook, Chapter 4 Prj Organization
 Risk management and insurances – Stellar
 Risk - MIT libraries
 Haimes, Risk modeling, assessment, and management

 Mun, Applied risk analysis : moving beyond uncertainty

 Flyvbjerg, Mega-projects and risk

 Chapman, Managing project risk and uncertainty : a

constructively simple approach to decision making

 Bedford, Probabilistic risk analysis: foundations and methods

 … and a lot more!