RMI 2302 EXAM 2 STUDY GUIDE MODULES 6 9 Module 6 Results of Decision Making Biases Risk Reward Incentive Systems Risk Reward o Relationship between risk and reward o Understanding this relation is crucial to critical decision making o Individuals Measured using expected utility How much reward is necessary to induce you to take risk Similarly how much are you willing to pay to avoid risk This is actually the entire basis of insurance people willing to pay to avoid risk Example From early lecture 5 wealth 50 50 chance of ending up with 1 or 9 dollars Utility function is the sq root function How much reward is necessary to get the individual to take o Organizations the risk Use expected value not expected utility No natural risk aversion Opportunity cost or cost of capital Most organizations project investments opportunities future cash flows from Discount those cash flows back to present value based on cost of capital Cost of capital is commensurate with riskiness of firm CAPM Only reward systemic risk Not diversifiable risk Efficient frontier o Gov t Society Measuring reward to society is difficult reward of national parks Many times government is the only entity able to take on risk regardless of reward Bias o What is a bias Subjective view probability different from objective Many sources Alter the decision making Problem when it ends up being significantly different from the model o Donald Rumsfeld Sec of Def GW Bush There are the known knowns These are the things we know There are the known unknowns That is to say there are things we know we don t know But there are also unknown unknowns These are the things we don t know we don t know Types of Bias o Age biases o Cultural biases o Experience biases o Gender biases o Media biases Incentives o Now that we know how people make decisions how do we get them to make decisions that are advantageous to us Incentives Things that motivate individuals to perform an action Incentives can be at the individual level organizational level or societal level Generally we refer to incentive structures o Study of Economics is basically a study of incentive systems o Beware The Law of Unintended Consequences o Political Incentives Short term vs long term planning Discount rate Types of Incentives o Financial Most incentives o Moral do the right thing o Natural curiosity fear anger pain joy pursuit of happiness o Coercive negative reinforcement o Personal vs social Module 7 Risk and Individuals o Overview of Risk for Individuals o Categories of looking at risk at the individual level Property Liability Life Health Financial o Why categorize Risk management techniques Categories may not be mutually exclusive some risks may appear in multiple categories o Risk Management for Individuals o Loss Exposures Any condition or situation that presents a possibility of loss regardless of whether that loss actually occurs o Three Elements to a loss exposure Asset exposed to loss Land buildings crops etc Personal property Your stuff furniture jewelry art autos watercraft etc Fire theft windstorm accidents lost pretty much anything you Cause of loss Financial consequences of the loss o Property o Asset exposed to loss Real property o Cause of Loss can think of o Financial Consequences Reduction in property value Lost income Increased expenses o Liability o Asset exposed to loss Money other financial assets General Special Punitive damages o Cause of Loss Claim lawsuit Civil law vs criminal law Tort contract statutory Negligence o Financial Consequences Defense costs Monetary damages o Specific Types of Liability o Property owners o Automobiles o Employer employee o Parents and children o Animals o Life Premature Death o Asset exposed to loss Your life o Cause of Loss Premature death illness accident stupidity o Financial Consequences o Financial Impact of Premature Death o Wage earning adult Married Single with dependents Single with no dependents o Non wage earning adult Married Single with dependents Single with no dependents o Child o Life Long Life o Asset exposed to loss Your savings retirement wealth o Cause of Loss Outliving assets expenses income for too long o Financial Consequences What happens when retired Income Expenses o Which increase o Which decrease Poor care poor genes bad luck injury illness etc Ability to earn income may decrease or cease as in premature death Living expenses may continue or increase Evaluate same exposure categories as premature death Poor care poor genes bad luck injury illness etc Ability to earn income may decrease or cease as in premature death Living expenses may continue or increase Evaluate same exposure categories as premature death o Health o Asset exposed to loss Your health livelihood o Cause of Loss o Financial Consequences o Health Disability o Asset exposed to loss Your health livelihood o Cause of Loss o Financial Consequences o Financial o Asset exposed to loss Your wealth o Cause of Loss o Financial Consequences Inadequate savings Back to work Can t retire o Individual Risk Management Health disability unemployment poor planning etc o Risk Management Process Determine Objectives Identify Risks Evaluate Risks Choose your alternatives Review Evaluate Implement o How do you apply it o What are your objectives 20 s 30 s 40 s 50 s 60 s 70 s o What are the risks Change throughout life what do you think they will be Change throughout life e g premature death 20 s not many people relying on you your income 30 s family life changing significant risk 40 s your grown up and don t even know it highest this risk will ever be 50 s risk beginning to diminish 60 s not as big an issue 70 s not an issue not an issue o How do you evaluate Frequency severity Death only happens once but probability does vary Severity does vary based on o Wealth o Income This is the first article of the yes no variety Written as a point counterpoint two different views of the risk reward associated with cognitive enhancement pills are explored o Stimulant drugs such as Ritalin and Adderall have been developed to help manage ADHD o Classified as Schedule II drugs by the DEA same as cocaine Illegal to take without a prescription federal offense o Have proven successful in managing ADHD o Evidence suggests helps many people focus and improves performance on some learning tasks e g memorizing o What are smart pills o Overview o What is the risk o Insomnia weight loss decreased appetite jitteriness o Increased risk of cardiovascular problems o
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