Nothing is more hair raising than exposure to risk without a sense of the level of that exposure. This is especially true in capital investment decisions.
Monte Carlo simulations perform risk analysis by building models of possible results by substituting a range of values—a probability distribution—for any factor that has inherent uncertainty and significant impact on the final result.
By using probability distributions, variables can have different probabilities of different outcomes occurring. Probability distributions are a much more realistic way of describing uncertainty in variables of a risk analysis and improve the quality of sensitivity analysis.
During a Monte Carlo simulation, values are sampled at random from input probability distributions. This is done hundreds or thousands of times, and results in a probability distribution of possible outcomes. It provides a much more comprehensive view of what may happen.
Advantages over deterministic, or “single-point estimate” analysis include:
- Probabilistic Results. Showing how likely each outcome is.
- Clearer Graphical Results. Visual presentation of probabilities.
- Improved Sensitivity Analysis. Sharper sensitivity analysis to show what counts.
- Scenario Analysis: Model repeated variations in combinations of factors to show which scenarios need further investigation.
- Correlation of Inputs. Represent how, in reality, when some factors goes up, others go up or down accordingly.
Done poorly or with low quality input data, the results can be potentially misleading – producing a level of certainty on the basis of some very uncertain assumptions.
Lytton Advisory holds an @Risk software licence which enable us to provide this type of probabilistic analysis to clients, helping them make better informed decisions. Examples of how we have applied this for clients include:
- Estimating financial costs of schedule delay on a major metropolitan public transport project.
- Assessing probability of breaching a cost contingency levels on a +$500 million infrastructure program.
- Building probabilistic NPV profiles in cost benefit analyses given uncertainty about key economic inputs.
Contact us today to find out how we might be able to help you.
On Tuesday I was very pleased to chat with students at Iona College who were considering careers in economics. A smart group of guys who asked some very intelligent questions. The future for economics looks bright.
While working recently in Kuwait, I was privileged to be invited to a diwaniya (https://en.wikipedia.org/wiki/Dewaniya) along with colleagues from my project team. This type of forum is fairly unique to Kuwait and it a key element of their civil society.
For around an hour we discussed industry policy with a number of leading lights from Kuwait’s business community. I learned a lot from them. The discussion took our project team beyond the numbers and statistics we were considering to just how the reforms might actually be implemented. The exchanges were robust but expressed in good humour and with great politeness.
I think these kinds of gatherings are extremely important in shaping consensus. Kuwait has hundreds of diwaniyas and candidates for public office often seek to turn up at as many as possible around election time. In my view, it removes a lot of the adversarial nature that characterises public discourse in Western countries. Where hard decisions are needed to effect significant change, a consensus based approach may deliver better outcomes than a crash or crash though approach.
Australia used to do evidence-based, consensus-driven public policy quite well. It was grounded in clearly explaining the need for change. I fear now that the people putting themselves forward for public office are increasingly driven more by populism and a startling touch of irrationality.
I am currently on assignment Kuwait, one of the oil drenched Gulf states. The economic incentives at play here are unlike anything I have ever seen. At university years ago we spent a couple of hours in undergraduate economics talking about rent seeking – looking for an economic gain without a reciprocal return to society through wealth creation.
Laid out before me is a whole economy resting on this premise and driven by the distribution of oil rents. Kuwait has been pumping around 3 million barrels of oil a day and is targeting 4 million with some urgency now oil prices have collapsed. Currently this earns them an oil rent (after costs of production and depending on the price) around US$60 million a day. When oil prices were over US$100 a barrel they were getting US$300 million a day. Kuwait has one of the highest dependencies on oil – some 93% of its revenues come from oil rents.
Some indicative figures provide context. The population of Kuwait is about 3 1/2 million people. Around one third of residents are Kuwaiti citizens, the vast majority of the remainder are guest workers. Guest workers remit around A$25 billion a year to their home countries. This is equivalent to 55% of the Kuwait national budget. Nine in ten Kuwaiti citizens are employed by the government. The country rests on a cash reserve of around US$600 billion.
All businesses, with a few limited exceptions, are required to be 51% owned by Kuwaitis. So there are a range of business partnerships that are not strictly commercial but compliance-based. At any stage, the dominant partner can take control of the business.
This creates some very peculiar incentives. Lack of permanency for guest workers provides little incentive to save, spend or invest in Kuwait. So Kuwait misses out on retaining a significant proportion of their remittances.
With significant reserves in the ground – over 75 years – there is little incentive to move away from this rent-seeking model and the inherent imbalances it introduces. However in the long term that transition will be necessary.
It will be fascinating to see how this plays out over time.
In the heart of the Kingdom of the Mouse at EPCOT today. Disney certainly has already created an immersive environment. It is a fully enclosed micro economy. The main point is that it is an opt-in environment. A flick of a switch, a click of a mouse and the consumer can easily be somewhere else. Disney is very shrewd with its franchises but they are only surface tales of eternal stories. Their ability is to tell them to mass markets. Coincidentally The Economist had a piece on the Magic Kingdom, here.
Few countries epitomise individualism and free markets as much as the United States. Large swathes of the economy are given over to commercial activity. The US is a global leader in investment, innovation and infrastructure systems. Also, a lot of infrastructure in the US has been privately developed, delivered and run over a long period of time.
Which is why it might be surprising that the last Report Card (2013) by the American Society for Civil Engineers so poor. One would have thought eagle eyed investors could create assets to address infrastructure needs. The engineers actually gave America a D+ and stated that by 2020 investment of some US$3.6 trillion is required. That is around US$11,250 for every man, woman and child. The next review is in 2017.
In contrast, the Institute of Engineers in Australia gave Australia a grade of C+ in 2010 on the back of a possible deficit in infrastructure spending of A$770 billion. That is around A$32,000 for every man, woman and child in Australia. It seems we need even more than our American cousins.
So who is doing better? It is hard to tell without know what assets each country already has. I suspect the level of future investment is partly a function of increasing demand and the need to replace of existing assets. It will be good to get some first hand insights when I am in the US in December.