Impact of Risk Specification on Valuation of Multi-dimensional Projects

Saurabh Bansal and Yaroslav Rosokha

Purdue University Economics Working Papers from Purdue University, Department of Economics

Abstract: Motivated by business situations in a number of domains, we show, using laboratory experiments, that subjective valuations of multi-dimensional risky projects are highly sensitive to the format of risk specifications. We considered a project that has two dimensions, each with an associated risk. A project would be considered a success when favorable outcomes occur on both dimensions. Participants were provided with the probabilities of success for each dimension in two different specifications. In the simple risk specification, each probability was specified as a point estimate. In the compound risk specification, each probability was specified as a two-point distribution. Structural analysis of the data shows that the widely reported overestimation of conjunctive probabilities under simple risk specification is reduced by a large margin under a compound risk specification. We also show that this mitigation occurs because individuals make valuation judgments as if the reduced probability of success is lower than normative probability. Effectively, we show that the two biases in processing conjunctive events and compound risk specifications act in opposite directions, and as outcome, judgmental valuations for a two-dimensional project are closer to the true value with compound risk specification (versus a simple risk specification). These results have an important implication for communicating risk: substituting compound risk specifications with simple risk specifications can lead to a systematic deterioration in the quality of project valuations that involve multiple risks.

Keywords: Risk Specifications; Multiple Risks; Behavioral Biases (search for similar items in EconPapers)
Pages: 32 pages
Date: 2016-08
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Persistent link: https://EconPapers.repec.org/RePEc:pur:prukra:1342

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