Evaluation of Certainty Equivalent

The certainty-equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. This will no longer give forecasts according to ‘best estimate.’ Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecasts or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments.

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