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Making a Decision Tree

A decision tree is a tool that helps calculate the expected values of the choices that are available to you.

It uses probabilities of events happening and estimates of each possible outcome to help you make a decision. For example, if you called in to a radio contest where you got a chance to choose between a 1 in 10 chance of winning fifty dollars, and a 1 in 100 chance of winning a thousand dollars, which would you pick?

The expected value of the first option is 10% x $50, or $5. The second option is 1% x $1,000 or $10. The second option has a better payout.

This example is simple. In most business decisions, there are many layers of things that have to happen to get to particular outcomes. Decision trees help organize these types of complicated scenarios.

The tool is called a decision tree because of the manner in which the decision points spread out like branches.

There is one big shortcoming to this tool. If you think about the example of the radio contest, risk adverse people might choose the lower expected value, because the odds of a positive outcome are ten times as great.

 

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