 Common spreadsheet mistakes in risk modeling | Vose Software

# Common spreadsheet mistakes in risk modeling

Quantitative risk analysis involves a wide range of skills and tasks that risk modelers need to have mastered before embarking on an important risk analysis of their own. Among the most over-looked and underestimated of these skills is knowledge of how to manipulate variables within Monte Carlo simulation models which is the standard modeling technique for risk analysis.

Add, subtract, multiply, divide – we have learned how to use them with numbers at school by the age of ten at the latest, and we take it for granted that we have mastered them. It is hard to imagine a risk analysis model in any field that does not include some of these four operations. Yet these basic operations very often do not work in the same way when those numbers are uncertain. Most risk analysis models to some degree incorrectly manipulate uncertain variables in a model, perhaps because we don’t give a second thought to calculations using + - * / .

There is a widely held belief that one can take a standard spreadsheet model (e.g. a cashflow model with EBITDA or NPV calculation) and simply replace any value within that model that is uncertain with a function that generates random samples from some distribution to reflect its uncertainty. People mistakenly think that the rest of the model’s logic can be left unchanged.

And it really does matter. Incorrect manipulation of uncertain variables in a model will almost always produce simulation results with something close to the correct average value, which people use as a ‘reality check’, but completely wrong spread around that average value. The net effect is usually that decision-makers are presented with a wildly inaccurate estimate of the uncertainty (risk) of the outcomes of different decision choices. Some may realize that the model results are unrealistic and dismiss them, while others won’t and will make misguided decisions.

## Mathematics

Most spreadsheets are made up of numbers and variables connected together with addition subtraction, multiplication and division. These operators (+, -, *, /) will not always work well when converting to a model where the values are uncertain:

Of the four operations, addition is the least problematic. The only issue that occurs is where the two variables being added are connected in some way (i.e. causally associated with each other either directly or indirectly so that their possible values are correlated). In other words, if the two variables you want to add together are affected by one or more of the same external factors then simple addition will very likely not be appropriate. If this is the case, the model should incorporate the inter-relationship using a correlation technique.

That issue aside, performing the simple possible addition of two uncertain variables gives a very nice way of illustrating how non-intuitive the results are from a Monte Carlo simulation – and therefore why it is so dangerous to rely upon one’s intuition when assessing whether the results look about right.

Let’s say that we have two costs – A and B, and we want to calculate the total C. If A = \$1, and B = \$4, we’d have C =  \$5. Now imagine that costs A and B are uncertain. A is equally likely to be somewhere between \$0.50 and \$1.50, and B is equally likely to be between \$3.50 and \$4.50. That means that C is also uncertain and must lie somewhere between \$4 and \$6. In fact, C would also most likely take a value of \$5, which can be shown pictorially like this: And in risk analysis modeling parlance like this:

Uniform(0.5,1.5) + Uniform(3.5,4.5) = Triangle(4,5,6)

You might be surprised that the uncertainty of C follows a Triangle shape instead of another rectangle (Uniform). When asked to guess what two Uniform variables sum to, the answer often given is another Uniform. It isn’t that intuitive, yet it is hard to think of any simpler distributions we might add together. The following graphs illustrate where the Triangle comes from: Upper left panel: A plot of Monte Carlo simulated values of A against C. For example, the bottom left corner shows samples where A and B were close to their minima (0.5 and 3.5 respectively to give a total C = 4) and the top right corner shows samples where A and B were close to their maxima (1.5 and 4.5 respectively to give a total C = 6). The range of the value of B is shown by the red arrows.

Upper right panel: The points are statistically evenly spread within his rhombus shape because A and B are uniformly distributed. Imagine that we split these simulated data in two according to the horizontal line shown …

Lower left panel: And then flip the position of the top half of the data. You can see that when projected onto the vertical axis the values of C follow a Triangle distribution

Lower right panel: Switch axes and we have a Triangle distribution. Note that the vertical axis now represents ‘probability since the height of the triangle is proportional to the fraction of simulated values that fall at or near the horizontal axis value.

In this example, the distributions sum to a Triangle because A and B follow Uniform distributions with the same width (of \$1). If the widths had been different, the resultant summation would have been trapezoidal, as shown by the following similar set of plots, where A = Uniform(0.5,1.5) and B = Uniform(3.5,5.5): ### Multiplication

One must first determine whether the two variables are correlated in some way. If so, use a correlation technique.

The next consideration is whether the multiplication is actually a summation. For example, imagine that a business owner expects to have 5000 paying customers visit a shop during a sales period, and each may spend \$20. The total sales revenue performed in a deterministic spreadsheet is then 5000 * \$20 = \$100,000, a short-hand way of adding up 5000 separate lots of \$20 (\$20 + \$20 + ... + \$20). Most business spreadsheet models will have many similar types of calculations multiplying number of units by cost or revenue per unit.

But there will obviously be considerable variation in how much each person spends. Let's say that variation can be described by a Lognormal(20,15) distribution, where 20 and 15 are the mean and standard deviation of the value of a random sale. The distribution looks like this, with a 3% chance of being above \$60, and a 24% chance of being below 10: To determine the distribution of total sales revenue we should add up 5000 separate Lognormal(20,15) distributions, since one sale might be very small, another very large. This formula:

= 5000 * VoseLognormal(20,15)

is incorrect, because whatever value is generated by the VoseLognormal function will be applied to all 5000 customers. For example, there is a 3% chance the function will generate a value greater than \$60, but the probability that all 5000 people will spend so much is infinitesimally small. The formula would grossly over-estimate the uncertainty of the revenue

The approach is to use an aggregate function.  In particular, the VoseAggregateMC (aggregate Monte Carlo) function provides a simple approach:

=VoseAggregateMC(5000,VoseLognormalObject20,15))

This function will sample 5000 times from the Lognormal distribution, add together the 5000 independent value, and return the summation to the spreadsheet. The difference between the two results is shown in the next image. The correct method has a much smaller uncertainty: ### Subtraction

Subtraction is to be avoided in a risk model if possible. As a general rule, only subtract constants from a random variable, or subtract a random variable from a constant.

Let’s say we have two costs A and B that sum to C, but we know the values of A and C. If A = \$1, and C = \$5, we could calculate B:  = \$5 - \$1 = \$4. But when the values of A and B are uncertain, we cannot do this calculation at all!

From the example above, we had:

A:         Uniform(0.5,1.5)
B:
Uniform(3.5,4.5)
C:
Triangle(4,5,6)

And we saw that A + B = C, i.e:

Uniform(0.5,1.5) + Uniform(3.5,4.5) = Triangle(4,5,6)

Simple algebra would have us believe that C – A = B, i.e.:

Triangle(4,5,6) - Uniform(0.5,1.5) = Uniform(3.5,4.5)

In fact the left and right sides of this equation are very different. If we calculated in a model

= Triangle(4,5,6) - Uniform(0.5,1.5)

in the hope of retrieving the correct distribution for B, we would in fact have grossly overestimated the uncertainty of B as shown in the following plot: What went wrong? Let’s look again at the scatter plot of the previous example: If the value of C were to be 5.5, as shown in the top arrow, the value of A can only lie between 1 and 1.5. Similarly, if C were 4.5, A must lie between 0.5 and 1. In other words, the possible distribution of A is dependent on the value of C, which is not accounted for in a simple formula like:

C – A = Triangle(4,5,6) - Uniform(3.5,4.5)

The general rule here is that one should avoid doing subtractions like C – A when using Monte Carlo simulation whenever the value of C incorporates the value of A. So, for example:

• C = total cost of running a factory, A = personnel cost, C-A will not calculate the non-personnel cost. Instead, you should construct your model the other way round - calculate the personnel costs and non-personnel costs, then add them together to obtain the total cost

• C = revenue, A = cost, then C-A will calculate the profit, as long as any relationship between C and A has been accounted for in the model (e.g. relationship to the volume of goods sold).

### Division

Nearly everyone who starts doing some risk modeling makes mistakes when they include division in their models. It is very confusing and unintuitive to begin with, so avoid using division in your models unless you have had some really good risk analysis training.

We can illustrate the problem using the example above for multiplication. From Central Limit Theorem we could have predicted that the total shop earnings would approximately follow a Normal(10000, 1061) distribution. The following plot compares the two: Imagine that we have this CLT estimate, and want to figure out how much each person spends. We might write this:

Normal(12000, 1061) / 5000

This is the average amount that each person spends in the shop, but it could also be the actual amount each individual person spends if they all spent the same amount. There is no distinction between the two in this calculation. However, if each customer spends an amount that is different and independent of other customers, there is no way to back-calculate the distribution of the individual expenditure (which was a Lognormal(20,15) you’ll remember). We cannot know with the above information what the distribution of the amount spent by individual customers is, but it turns out that we can state the mean and standard deviation if they all make purchasing decisions independently.

Looking at the problem the other way round, we might want to know how many individuals following a certain distribution would be needed to have a certain total. For example, imagine that we have a sales target of \$50,000, and a random sale follows a Lognormal(20,15) distribution. This formula would be incorrect:

=50000 / VoseLognormal(20,15)

because it would be assuming all sales were the same amount. Instead, we should use this ModelRisk formula:

=VoseStopSum(VoseLognormalObject(20,15),50000)

The VoseStopSum function is essentially the reverse of the VoseAggregateMC function. Again, the results using the correct method are far narrower than the incorrect method: ## Representing an uncertain variable more than once in the model

When we develop a large spreadsheet model, perhaps with several linked sheets in the same file, it is often convenient to have some parameter values that are used in several sheets appear in each of those sheets. This makes writing formulae and tracing back precedents in a formula quicker. Even in a deterministic model (i.e. a model where there are only best guess values, not distributions) it is important that there is only one place in the model where the parameter value can be changed (at Vose Software we use the convention that all changeable input parameter values or distributions are labelled blue, as you will see in the example models). There are two reasons: first it is easier to update the model with new parameter values; and second it avoids the potential mistake of only changing the parameter values in some of the Cells in which it appears, forgetting the others, and thereby having a model that is internally inconsistent. For example, a model could have a parameter 'Cargo (mt)' in Sheet 1 with a value of 10,000 and a value of 12,000 in Sheet 2.

It becomes even more important to maintain this discipline when we create a Monte Carlo model if that parameter is modelled with a distribution. Although each Cell in the model might carry the same probability distribution, left unchecked each distribution will generate different values for the parameter in the same iteration, thus rendering the generated scenario impossible.

### How to allow multiple occurrences of the same uncertain parameter

If it really is important to you to have the probability distribution formula in each Cell where the parameter is featured (perhaps because you wish to see what distribution equation was used without having to switch to the source sheet, we suggest that you make use of the U parameter in ModelRisk's simulation functions to ensure that the same value is being generated in each place:

Cell A1: =VoseNormal(100,10,Random1)

Cell A2: =VoseNormal(100,10,Random1)

where Random1 is some Uniform(0,1) distribution will generate the same values in each cell.

### More disguised versions of the same problem

The error described so far is where the formula for the distribution of a random variable is featured in more than one Cell of a spreadsheet model. These errors are quite easy to spot. Another form of the same error is where two or more distributions incorporate the same random variable in some way. For example, consider the following problem:

A company is considering restructuring its operations with the inevitable layoffs, and wishes to analyze how much it would save in the process. Looking at just the office space component, a consultant estimates that if the company were to make the maximum number of redundancies and outsource some of its operations, it would save \$PERT(1.1, 1.3, 1.6)M of office space costs. On the other hand, just making the redundancies in the accounting section and outsourcing that activity, it could save \$PERT(0.4, 0.5, 0.9)M of office space costs.

It would be quite natural, at first sight, to put these two distributions into a model, and run a simulation to determine the savings for the two redundancy options. On their own, each cost saving distribution would be valid. We might also decide to calculate in a spreadsheet Cell the difference between the two savings, and here we would potentially be making a big mistake. Why? Well, what if there is an uncertain component that is common to both office cost savings? For example, if inside these cost distributions is the cost of getting out of a current lease contract, uncertain because negotiations would need to take place. The problem is that by sampling from these two distributions independently, we are not recognizing the common element, which is a problem if that common element is not a fixed value, because it induces some level of correlation.

## Calculating means instead of simulating variation

When we first start thinking about risk, it is quite natural to want to convert the impact of a risk to a single number. For example, we might consider that there is a 20% chance of losing a contract, which would result in a loss of income of \$100,000. Put together, a person might reason that to be a risk of some \$20,000 (ie 20% * \$100,000). This \$20,000 figure is known as the 'expected value' of the variable. It is the probability weighted average of all possible outcomes. So, the two outcomes are \$100,000 with 20% probability and \$0 with 80% probability:

Mean risk (expected value) = 0.2*\$100,000 + 0.8*\$0 = 20,000

The graph below shows the probability distribution for this risk and the position of the expected value. Distribution for risk with 20% probability and \$100,000 impact.

Calculating the expected values of risks might also seem a reasonable and simple method to compare risks. For example, in the following table, risks A to J are ranked in descending order of expected cost: If a loss of \$500k or more would ruin your company, you may well rank the risks differently - for impacts exceeding \$500k, it is the probability of occurrence that is more important: so risks C, D, I and to a lesser extent, J pose a survival threat on your company. Note also that you may value risk C as no more severe than risk D because if either of them occur your company has gone bust.

On the other hand, if risk A occurs, giving you a loss of \$400k, you are precariously close to ruin: it would just take any of the risks except F and H to occur (unless they both occurred) and you've gone bust.

Looking at the sum of the expected values gives you no appreciation of how close you are to ruin. How would you calculate the probability of ruin? The model solution can be found in this example model. Figure 2 plots the distribution of possible outcomes for this set of risks. Probability distribution of total impact from risks A to J

### Why calculating the expected value is wrong

From a risk analysis point of view, by representing the impact of a risk by its expected value we have removed the uncertainty (i.e. we can't see the breadth of different outcomes), which is a fundamental reason for doing risk analysis in the first place. That said, you might think that people running Monte Carlo simulations would be more attuned to describing risks with distributions rather than single values but this is nonetheless one of the most common errors.

Another, slightly more disguised example of the same error is when the impact is uncertain. For example, let's imagine that there will be an election this year and that two parties are running: the Socialist Democrats Party and the Democratic Socialists Party. The SDP are currently in power and have vowed to keep the corporate tax rate at 17% if they win the election. Political analysts reckon they have about a 65% chance of staying in power. The DSP promise to lower the corporate tax rate by one to four percent, most probably 3%. We might chose to express next year's corporate tax rate as:

Rate = 0.35*VosePERT(13%,14%,16%) + 0.65*17%

Checking the formula by simulating we'd get a probability distribution which could give us some comfort that we've assigned uncertainty properly to this parameter. However, a correct model would have drawn a value of 17% with probability 0.65 and a random value from the PERT distribution with probability 0.35. How could you construct that model? This link gives a couple of examples. The correct model would have considerably greater spread: the two results are compared below: Comparison of correct and incorrect modeling of corporate tax rate for the SDP/DSP example.