Decision Trees

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Decision Tree

A Decision Tree is a diagram that looks at alternative courses of action and their possible outcomes

There are 2 stages to using Decision Trees:

  1. Draw the Decision Tree (including all probabilities and outcomes)

  2. Use expected values at all outcome points to make decisions.

Drawing the Decision Tree

  • Draw the tree from left to right

  • A square represents a Decision

  • A circle represents an Outcome

  • At a Decision Square - a branch from it represents a potential event - with a probability of it happening attached

Diagram

Figure 1:

There are two branches coming off the initial decision point - the top branch has a certain outcome

The lower branch has two possible outcomes, and a further 2 possible outcomes for each of these

The next step would be to label the tree and put the cash inflows/outflows and probabilities in

Evaluation of the Tree

Evaluate the tree from right to left

  • Calculate an Expected Value at each Outcome circle

  • Choose the best option at each Decision square

  • Finally, recommend the option with the highest expected value

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