Risk: Life is inherently risky... Everything we do, comes with a risk... Even me making the decision to write this article has many risks, as in: I run the risk of my article not being read or read but not understood or read, understood but criticized... The point is how much risk can one handle in making a decision... Now, in decision making terms, risk could be the inability of an alternative in reaching the objective... Risk is a direct indication of a highly probable nature of the consequences... For a vivid picture, let us say I have two investment options: Option (A) and Option (B)... And lets say option (A) is CERTAINLY going to yield me a return of 10 monetary units.. and option (B) is a 50-50 LOTTERY between a return of 30 monetary units and a return of nothing... The expected monetary payoffs* for both the options would be for (A)- 10 and for (B)- 15.... So in monetary terms, option (B) is better... Now lets define some units, Option (A) is a CERTAIN Rs. 10/- and Option (B) is a 50: 50 GAMBLE between Rs.0/- and Rs.30/-... Lets say I go with the expected pay- off theory and I select option (B)...Now let me increase the scale of investment... The options are (A)- a certain Rs. 10 lac/- and (B)- an uncertain 50-50 game between Rs.0/- and Rs. 30 lac/-.... Now lets come again on the decision... Would I still go with option (B)??? The thing is: I may value Rs. 30/- thrice as Rs. 10./-.. But I may not value Rs. 30 lac/- thrice more than Rs. 10 lac/-... If such a case, wherein my utility for money does not jump as high as the money itself (decreasing utility function), then I can call myself a risk averse person... The other case when my utility for money jumps higher than the money, shows a risk seeking tendency.... When my utility jumps as good as my money, then I am risk neutral.... The thing is somewhere, there is going to be a point of uncertainty, where I would be indifferent between both the investment options... My utility for both the alternatives is going to be same at this point... Let me say my utility for Rs. 0 is 0, for Rs. 10 lac/- is 80 and for Rs. 30 lac/- is 100, (notice the jump from 0 to 10 is 80, but the jump from 10 to 30 is not 160, but rather only 20 to 100- showing that I am risk averse)... I now obtain an indifference point at 20-80 between Rs.0 and Rs. 30 lac... It means that I am indifferent between options (A) and (B), only if (B) is a 20-80 game between nothing and Rs. 30 lac... and since it is not, I highly favor option (A)....
Regret: Regret can be the loss of an opportunity that previously existed for disposal.... In decision making terms, regret is the difference/ ratio between the consequence by choosing a particular alternative and the best consequence, that can incur out of the same state of nature (obviously by choosing a different alternative).... Let us modify the same example by saying both the investment options are lotteries (uncertain), both options yield two different pay-offs depending on the current state of market... The state of market is not easy to predict and not possible to control... Lets say in case of a strong market, option (A) yields a return of 8 monetary units and option (B) yields 14 monetary units.... In case of a weak market, option (A) yields a return of 7 units and option (B), a return of 5 units... We see that the best consequence (14) is in option (B) for a strong market and the best consequence (7) is in option (A) for a weak market.... Difference regret is the difference between the pay-off and a better pay- off... So for a strong market, regret is 6 for option (A) and 0 for option (B) {Coz there isn't a better pay-off than 14 for a strong market}.... It means that I ll regret the loss of 6 units if I choose option (A) provided the market happens to be strong... For a weak market, regret is 0 for option (A) and 2 for option (B)... For option (A), my regrets are {6,0} and for option (B), my regrets are {0,2}... So at worse, I am going to regret a loss of 6 units for option (A) and a loss of 2 units for option (B).... Obviously I want to regret less, so I am going to opt for option (B) investment, where even at worst, I ll only regret the loss of an opportunity to make 2 extra units...
*The expected value/ payoff is often referred to as the "long-term"average or mean . This means that over the long term of playing a game/ lottery over and over, you would expect this average.
**Don't ask me where did I get all this data from...?? The pay- off values (like Rs. 10 lac/-, Rs. 30 lac/- ) are all solid figures, the probability values (like 50-50) are obtained from market analysis/ prediction/ forecasting and the utility values (like 0, 80, 100) are obtained from the decision maker... The Expected Values and Expected Utilities are the calculated outputs**
**Strong Market, is one where buyers outnumber sellers, and the prices are in a general uptrend... and the opposite is a Weak Market.**
A novel and a subsequent movie.... It has a significant plot-line with the backdrop of the infamous Nazi Holocaust camp at Auschwitz during WWII, on how Sophie is made to choose between her son and her daughter as to who lives and who dies in the death camp and when she refuses to make a decision, the Nazi officer tells her that both her children will be put to death..... She ultimately chooses her son to live, the plot ultimately ending with Sophie committing suicide after taking cyanide... Sophie's choice is a case of deciding between two unbearable alternatives and her death is a manifestation of severe undeserved guilt, a super-set of emotional regret...
Read More: Google Sophie's Choice
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