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

Today, recitation Joe Gifun, MIT facility

Next Friday, March 3rd, Tour PDSI construction site

email Sharon Lin the team info by midnight, tonight

Monday Feb 27 - Student Experience Presentation
Wed March 1st Assignment 2 due

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
PLANNING

DEVELOPMENT CLOSEOUT

Financing&Evalua
tion
Risk
Analysis&Attitude

OPERATIONS

Risk Management Phase

FEASIBILITY

DESIGN
PLANNING

DEVELOPMENT CLOSEOUT

OPERATIONS

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 dont
mind losing as much

Risk attitudes change over

Time
Circumstance

Decision Rules

The pessimistic rule (maximin = minimax)

The conservative decisionmaker seeks to:

The optimistic rule (maximax)

maximize the minimum gain (if outcome = payoff)

or minimize the maximum loss (if outcome = loss, risk)

The risklover seeks to maximize the maximum

gain

Compromise (the Hurwitz rule):

Max ( min + (1- ) max) , 0 1

= 1 pessimistic
= 0.5 neutral
= 0 optimistic

The bridge case unknown

probties
$ 1.09 million
replace
$1.61 M

repair

$0.55
$1.43

Investment PV

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

probties
$ 1.09 million
replace
0.25
repair

0.5

$1.61 M
$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

Buy soon

Buy later

-100

-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

Buy soon

Buy later

-100

0. 5
0.25

-125
-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) =

Defining the Preference

Function

Suppose to be awarded a $100M

contract price
Early estimated cost $70M
What is the preference function of
utility
cost?

Preference means utility or satisfaction

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

preference fn f faced with an

investment c that provides

.25

Certainty equi
of investment

.5*$20,000+.5*$0=$10000

Average satisfaction with the

investment=

.50

Average money from investment =

50% chance of earning $20000

50% chance of earning $0

Mean satisfaction with

investment

.5*f($20,000)+.5*f($0)=.25

This individual would be willing to

trade for a sure investment yielding
satisfaction>.25 instead

Can get .25 satisfaction for a sure f 1(.25)=$5000

Mean valu
Of investm

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

$5000

Certainty Equivalent
Example
Consider a risk averse
individual with

Example Contd (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

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)]

Uncertainty with respect to consequence c

Non-linear preference function f

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 f1(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-Optima
For decision D2
Replace
MTTF 10.0000
Cost 1.00

C3
MTTF 6.6667
Cost 0.30
C4
MTTF
Cost 0.00

5.7738

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

Assignment PS3 posted on Stellar due date March

24

Phase 2 due March 17th

Phase 3 detailed description posted on Stellar, due May 11

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 students 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

Key insight: NPV does not work well with

uncertain costs/revenues

E.g. option to abandon a plant, expand bldg

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

Short-term cost and flexibility

Overlapping design & construction and different

construction activities limits changes
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!