www.epixanalytics.com Good Practices and Common Mistakes Huybert Groenendaal, PhD, MBA EpiX Analytics © EpiX Analytics LLC
www.epixanalytics.com
Good Practices and Common Mistakes
Huybert Groenendaal, PhD, MBA
EpiX Analytics
© EpiX Analytics LLC
� Financial industry
� Health / Food safety
� Energy, oil & gas
� Many others….
Risk analysis: many applications
1. EpiX Analytics specialized risk analysis and modeling company
2. Focus: Quantitative risk analysis & modeling
Goal: Improving decision-making
Services: Consulting, training & research
3. Experience in a wide range of fields:� Pharma
� Mining
� Manufacturing
� Transportation
� Insurance
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• Cost and schedule estimation
• Asset allocation
• Sales Forecasting
• Financial Analysis (NPV)
• Anti-microbial risk analysis
• Portfolio forecasting
• Pricing decisions
• Commission Estimation
• Reliability
• Inventory Optimization
• Evaluating of mining prospects
• Mine production forecasting
• Import risk analysis
• Electricity Price Forecasting
• R&D portfolio optimization
• Business Development Deal
Structuring
• Pharmacoeconomics
• Health and Epidemiology
• Budgeting
• Financial options
• Venture capital
• Hedging & VaR calculation
• Early drug development
• Many more…..
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Monte Carlo & @RISK:Many applications and case-studies
Free Monte Carlo and @RISK training and reference tool:
http://www.epixanalytics.com/ModelAssist.html
� $500 Risk Analysis Training tool
� Based on 20+ years of risk analysis consulting and training expertise
� Within ModelAssist, page numbers are Mxxxx. For example, M0407 will get you to the “Selecting the appropriate distributions for your model”
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ModelAssist for @RISK
So, now you are an @RISK user, but…
� What is important?
How do I start and what should I focus on?
� Do I maybe make mistake?
What should I look out for?
Goal of this seminar:
Share important good practices and common
mistakes (and how to prevent them)
Goal of this seminar:
Share important good practices and common
mistakes (and how to prevent them)
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Preventing common mistakes:
1. Multiply your efforts when multiplying
2. Software is no substitute for critical thinking…
3. Value your relationships!
Good practices:
1. Start with a ‘blue-print’
2. Check/verify your model!
3. Educate and engage your executives!
Good practices and common mistakesQuick overview
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� What is the mistake?
Using probability distributions as if they were fixed
numbers (e.g. multiplying, subtracting) M0089
� A simple example:
� Bank offering loans
� Number of clients taking a loan uncertain
� Size of the loan vary quite widely
� What will be total annual interest revenue?
Multiply your efforts when multiplying Preventing common mistake #1
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Multiply your efforts when multiplying Preventing common mistake #1
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© EpiX Analytics LLC
Multiply your efforts when multiplying Preventing common mistake #1
� Some other examples:1. Forecasting demand on services team (e.g. hours) based
on number of demands and length of calls in order to forecast and optimizing hiring needs;
2. Total exposure to credit risk, operational risks, etc.
3. Total costs of building 5 pumping stations
when building a 100-mile natural gas pipeline
4. Total amount of pig meat eaten by families who own pigs themselves
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Case Study: Large Oil and Gas companyIncorrect multiplying
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� Company developed
Monte Carlo model to
evaluate alternative
portfolios of natural gas
wells
� Incorrectly used
multiplication of
distribution and as a
result the company
greatly overestimated the
risk in its portfolio
Background:
� Corrected the Monte Carlo model using Central Limit Theory (CLT)
� Included efficient use of Stochastic Optimization (i.e. OptQuest)
� Company now uses Monte Carlo and Stochastic Optimization to optimize its use of resource (budget, manpower, potential wells)
Solution:
� What is the mistake?
Rely too much on Monte Carlo software without
thinking critically
� A simple example:
� You have some data on historical
annual returns of some global real estimate fund;
� Open up @RISK, click “Fit to data” M0198
� ‘Automatically’ select the distribution that has the highest
GOF statistic M0211
Software is no substitute for thinking…Preventing common mistake #2
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-4 -2 0 2 4 6 8
10
12
14
Software is no substitute for thinking… Preventing common mistake #2
� Some other examples:
� ‘Batch fitting’ distributions to data
(Does fitting a parametric distribution even make sense?)
� Using rank-order correlations because it is the only
correlation pattern that is explicitly including within @RISK;
� Using a GARCH (General AutoRegressive Conditional
Heteroskedasticity ) time-series to forecast sales based on
sales of last 5 years
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� What is the mistake?
Omit including relationships within Monte Carlo
models
Important rule: Every iteration (all 10,000) has to be a
possible future scenario
� Quick examples:
� Forecasting investment portfolio in multiple assets;
� Financial analysis of new product with uncertain price,
demand, level of competition, etc.
� Evaluating project cost and schedule;
Value your relationships!Preventing common mistake #3
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Value your relationships! Preventing common mistake #3
� Important:
� Omitting to include relationships typically results in the
under-estimation of risk;
� Many @RISK user only use the rank-order correlation, but
there are many alternative methods to include relationships:
� Envelop method M0146
� Lookup tables; M0275
� Logical relationships (IF-statements etc.) M0097
� The bootstrap M0444
� Relationship based on a regression (linear or non-linear)
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General recommendation: Only use rank-order correlation
if no other correlation methods can be used!
Value your relationships! Preventing common mistake #3
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Envelop method
Lookup tables
Regression Bootstrap
Conditional logic
Preventing common mistakes:
1. Multiply your efforts when multiplying
2. Software is no substitute for critical thinking…
3. Value your relationships!
Good practices:
1. Start with a ‘blue-print’
2. Check/verify your model!
3. Educate and engage your executives!
Good practices and common mistakesQuick overview
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� Too often, risk analysis is equated to just “adding
@RISK to an existing Excel model
� Why a blueprint?
� Forces the team to think through the model before
building it;
� Allows everyone to provide inputs/data/ideas before
constructing model
� Ensures that the decision-questions are being answered;
� Results in better constructed models;
� Often greatly reduces time to build a model
Start with a blueprint!Good practice #1
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� Why also a blueprint?
Start with a blueprint!Good practice #1
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0
0Size of the model / amount of detail
Perceived accuracy
Complexity
Time & effort
Accuracy
Transparency
Case Study: Pharmaceutical firmMore detail can back-fire
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� Company tried to use
Monte Carlo to support
R&D / drug development
decision, but developed
very complex model.
� While realistic, the Monte
Carlo model was too
difficult for users to
employ and not
transparent for
management
Background:
� Focused on decision-
questions
� Involved management in
model design
� Built Monte Carlo model
in close collaboration with
users
Company now uses Monte
Carlo simulation to
analyze the risks around
every new product
Solution:
� Remember, every iteration has to represent a
possible further scenario
� All too often models are built, but no time is spent
on verifying that the Monte Carlo model works as
expected/required
Check/verify your model!Good practice #2
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� Some very simple steps to build robust models and
verify they work as expected M0295
� Separate inputs (e.g. min, ml, max) from the model;
� Once the model is built, add graphs!
� Before running 10,000 MC simulation, review 10-20
individual iterations (F9 button)
� Documenting models pays off!
Check/verify your model!Good practice #2
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Educate and engage your executives!Good practice #3
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� Support from senior management critically important
� No understanding � no trust in model �
No support of decision � risk analysis useless!
� Involve management in framing the decision-questions,
determining alternative actions and looking at possible
data or sources of information
Educate and engage your executives!Good practice #3
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Presenting results:
� Limit use of hard-to-understand statistical measures
� Range of visual graphics for clear communication
Start simple, identify one or two important projects that can serve as pilot project to show the use of @RISK
Don’t focus on the model, but encourage communicating and thinking in probabilistic terms!!
Summary:
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Preventing common mistakes:
1. Multiply your efforts when multiplying
2. Software is no substitute for thinking…
3. Value your relationships!
Good practices:
1. Start with a ‘blue-print’
2. Check your model!
3. Educate and engage your executives!
Dr. H.GroenendaalManaging partner
EpiX Analytics [email protected]
P: 303 440 8524
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Questions?