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Bayesian evaluation and selection strategies in portfolio decision analysis

This paper discusses Bayesian evaluation and selection strategies in portfolio decision analysis, emphasizing the significant impact of estimation uncertainties on project selection outcomes. Traditional selection methods often rely on uncertain value estimates, leading to post-decision disappointment when true performance deviates from predictions. By employing Bayesian analysis, the expectation of project values can be improved, resulting in better portfolio choices and reduced disappointment. The paper illustrates this approach through examples featuring various projects and proposes methods for determining the value of additional information to optimize project selection.

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Bayesian evaluation and selection strategies in portfolio decision analysis

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  1. Bayesian evaluation and selection strategies in portfolio decision analysis E. Vilkkumaa, J. Liesiö, A. Salo EURO XXV, 8-11 July, Vilnius, Lituhania The document can be stored and made available to the public on the open internet pages of Aalto University. All other rights are reserved.

  2. Sports Illustrated cover jinx • Apr 6, 1987: The Cleveland Indians • Predicted as the best team in the American League • Would have a dismal 61–101 season, the worst of any team that season

  3. Sports Illustrated cover jinx • Nov 17, 2003: The Kansas City Chiefs  • Appeared on the cover after starting the season 9-0 • Lost the following game and ultimately the divisional playoff against Indianapolis

  4. Sports Illustrated cover jinx • Dec 14, 2011: The Denver Broncos • Appeared on the cover after a six-game win streak • Lost the next three games of the regular season and ultimately the playoffs Teams are selected to appear on the cover based on an outlier performance 

  5. Post-decision disappointment in portfolio selection = Selected project = Unselected project Size proportional to cost • Selecting a portfolio of projects is an important activity in most organizations • Selection is typically based on uncertain value estimates vE • The more overestimated the project, the more probably it will be selected • True performance revealed → post-decision disappointment

  6. Bayesian analysis in portfolio selection • Idea: instead of vE, use the Bayes estimate vB=E[V|vE] as a basis for selection • Given the distributions for V and VE|V, Bayes’ rule states • E.g., V~N(μ,σ2), VE=v+ε, ε~N(0,τ2) → V|vE~N(vB,ρ2), where f(V|VE)f(V)·f(VE|V) →

  7. Bayesian analysis in portfolio selection • Portfolio selected based on vB • Maximizes the expected value of the portfolio given the estimates • Eliminates post-decision disappointment • Using f(V|VE), we can • Compute the expected value of additional information • Compute the probability of project i being included in the optimal portfolio

  8. Example • 10 projects (A,...,J) with costs from 1 to 12 M$ • Budget 25M$ • Projects’ true values Vi ~ N(10,32) • A,...,D conventional projects • Estimation error εi ~ N(0,12) • Moreover, B can only be selected if A is selected • E,...,J novel, radical projects • More difficult to estimate: εi ~ N(0, 2.82)

  9. Example cont’d = Selected project = Unselected project Size proportional to cost True value = 52 Estimated value = 62 True value = 55 Estimated value = 58

  10. Value of additional information = Selected project = Unselected project Size proportional to cost • Knowing f(V|vE), we can compute • Expected value (EVI) of additional information VE • Probability that project i is included in the optimal portfolio EVI for single project re-evaluation Probability of being in the optimal portfolio close to 0 or 1

  11. Value of additional information • Selection of 20 out of 100 projects • Re-evaluation strategies • All 100 projects • 30 projects with the highest EVI • ’Short list’ approach (Best 30) • 30 randomly selected projects

  12. Conclusion • Estimation uncertainties should be explicitly accounted for because of • Suboptimal portfolio value • Post-decision disappointment • Bayesian analysis helps to • Increase the expected value of the selected portfolio • Alleviate post-decision disappointment • Obtain project-specific performance measures • Identify those projects of which it pays off to obtain additional information

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