How to Measure Anything Workbook: Finding the Value of Intangibles in Business

CHAPTER 6 Quantifying Risk through Modeling

LEARNING OBJECTIVES

• Describe some common problems with the way risk is usually measured.
• Describe the placebo effect in risk management.
• Describe the origins of the Monte Carlo simulation.
• Run a simple Monte Carlo simulation in Excel.
• Describe three frequency distributions and how each might be used in Monte Carlo simulations.
• Review some of the more advanced Monte Carlo concepts provided in the chapter.
• Define and give an example of the “risk paradox.”

CHAPTER OVERVIEW

Risk is a foundation of other important measurements that support decisions, but is not assessed adequately in most organizations. The Monte Carlo simulation uses ranges to represent uncertainty rather than point values, and generates many possible scenarios that allow us to get a more realistic sense of the risks involved. These calculations are practical and can be accomplished with Microsoft Excel. An understanding of standard probability distributions, such as the normal and binary, is helpful. Other resources are provided, and future directions for “probability management” are outlined.

There is a tendency in business to use quantitative risk analysis for routine operational decisions only, while critical strategic decisions are left to inferior means of analysis. Research on use of Monte Carlo tools has demonstrated that they improve a firm’s overall financial performance. Recommendations for probability management are outlined.

QUESTIONS

1. True or False: ...