Reviewed by Oct 05, 2020| Updated on
A tree diagram is a method in the fields of general mathematics, probability, and statistics to measure the number of possible outcomes of an event or problem and to present those potential outcomes in an orderly fashion.
Tree diagrams are very flexible and can be useful in many areas, including finance and are also called probability trees or decision trees.
A tree diagram allows a user to start at a single point and make mutually exclusive decisions. Alternatively, it can encounter mutually exclusive events to follow a path down the tree branches. Using a tree diagram is simple once each node is assigned the proper values. A likelihood must be allocated to the chance nodes, which represent a potential outcome.
Decision nodes ask a question, and answer nodes respond to them in terms of "yes" or "no". Also, a benefit is associated with a node, such as a cost or a reward. Tree diagrams combine a decision's odds, choices, costs, payouts, and offer a strategic response. In finance, given the price of the underlying security at any point in time, we can model the put or call option price using a decision tree.
The concept behind a tree diagram is to start with all, or one, on the left. The branch splits into a smaller branch for every outcome when there are many potential outcomes.
The diagram begins at a single node, with branches extending to additional nodes, representing decisions or events which are mutually exclusive. The review will start at the first blank node. An event or decision leads to node A or B, known as secondary nodes. Additional decisions or events may arise from these secondary nodes leading to the third level of nodes before a conclusion is reached.
Tree diagrams are used in strategic decision-making, business valuations, or probability estimates, in addition to mathematics.