Impact of Compound and Reduced Specification on Valuation of Projects with Multiple Risks

Several firms make business decisions based on risk specifications or estimates provided by domain experts. But research on whether the format of risk specifications systematically affects decision making in multidimensional environments is scarce. Using laboratory experiments, we show that subjective valuations of projects with multiple risks are highly sensitive to the format of risk specification. In the experiments, participants considered a project that had two risks and would be considered a success when favorable outcomes occurred on both risks. Participants were provided with the probabilities of success for each risk in two different specifications. In the reduced specification, each probability was directly specified. In the compound specification, each probability was specified as a two-point distribution. The data showed that under the reduced specification, decision-makers’ perceived value of the project was higher than its true value, because of conjunctive probability bias in which decision makers overestimated the conjunctive probabilities. Under compound specification, however, judgmental valuations were subject to two biases that acted in opposite directions and, as a net outcome, managerial valuations were closer to risk-neutral valuations.