Risk in Layman Terms for Absolute Beginners

Suppose you are to be a chief risk manager at HOME INC.

You have a total of W = 1000$ at HOME INC.

Suppose your company has an employee, a very bad dog, "Toto" who has just scratched your door and made it useless.

You go to your nearest retail hypermarket to ask for a replacement.

There you are given three options:

Door 1: Reliablus Inc.

This door is extremely strong has no chance of someone lockpicking. Even Danny Ocean with his Ocean’s Eleven with their advanced gear cannot break-in.

Cost: 300$

Door 2: Moderatus Inc.

This door is moderately strong has a 50% chance of someone lockpicking the door.

Arnie might be able to break the door if he kicks it hard enough. But that is true with any door in the 80s.

Cost: 150$

Door 3: Defectivus Inc.

This door has a 100% chance of someone lockpicking the door. A “How to pick a lock?” read on wikiHow is enough.

Cost: 50$

Also, there is an l = 40% chance for the house to get robbed and all leftover money will be lost.

Risk Management is a life skill that one undertakes when that person faces uncertainty that matters.

This situation makes you analyze the Risk involved in any of the three options:

The first option is the least risky but has the least payoff if nothing happens while the third option has the least payoff if someone attempts to picklock it.

Case 1:

If there is a robbing attempt: P = 0.4

Expected Total Loss for Case 2= Cost of Door + Expected Cost of Robbery

Door 1:

Expected Total Loss for Case 1 = 300$

Door 2:

Expected Total Loss for Case 1 = 150 $ + 0.5 * (1000-150) = 575 $

Door 3:

Expected Total Loss for Case 1 = 1000$

Case 2:

If there no robbing attempt: P = 0.6

Expected Total Loss for Case 2 = Cost of Door

Door 1:

Expected Total Loss for Case 2 = 300$

Door 2:

Expected Total Loss for Case 2 = 150 $

Door 3:

Expected Total Loss for Case 2 = 50 $

A cumulative of both cases:

Expected Total Loss

Door 1:

Expected Total Loss = 300$

Door 2:

Expected Total Loss = 0.4 * 575 + 0.6 * 150 = 320$

Door 3:

Expected Total Loss = 430$

We see that there is a maximum total loss in Door 3 and least in Door 1 Q. Does that mean Door 1 is the best option?

A novice risk manager would say Yes but the answer is it really matters what your Utility is

Are you a Risk Loving person or are you Risk Averse?

This Example gives us a basic idea of how Risk works in real life.

Thank You!