Friday, March 05, 2010

Continuum of Pure Uncertainty and Certainty

Prof Hossein Arsham makes an excellent case for using probabilistic (i.e., stochastic) models when confronted with "risky" decisions. His continuum of pure uncertainty and certainty is instructive for analysts and decision makers alike:
The domain of decision analysis models falls between two extreme cases. This depends upon the degree of knowledge we have about the outcome of our actions, as shown below:

Ignorance     Risky Situation     Knowledge
Uncertainty      Probabilistic    Deterministic

One "pole" on this scale is deterministic... The opposite "pole" is pure uncertainty. Between these two extremes are problems under risk. The main idea here is that for any given problem, the degree of certainty varies among managers depending upon how much knowledge each one has about the same problem. This reflects the recommendation of a different solution by each person.
The truth is that few financial decisions are made in an environment of complete knowledge, begging the question as to why deterministic models continue to prevail upon management. I maintain that the future of financial economics is probabilistic.

Source: Tools for Decision Analysis

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