How Expected Value Can Help You Make Good Decisions (Part 2)
Learning to take calculated risks when the outcome is uncertain is a matter of skill and intelligent calculation. Get-It-Done Guy explains how to make any uncertain decision.
Page 2 of 2
Making decisions using expected value calculations is a way of life.
I’d use that information to calculate the expected value using the range of conditions and stats from the Blue Book site. For the sake of simplicity right now, let’s just assume the car is worth $12,000. The expected value of the Craigslist ad is 97% x $0 + 3% x $12,000 or $360. Now we subtract the $5,000 purchase price for a final expected value of -$4,640.
A little research showed that Melvin’s $118,000 opportunity was really an expected loss of $4,640. Melvin used his gut for both the values and probabilites. His gut was wrong. You and I do our research, however, and realize this is not a positive expected value situation.
Remember to Factor Up Front Costs into the Expected Value
When you’re calculating expected value, remember you’re not just looking at payoffs or losses, but also the money you’ll have to put in up front. In Melvin’s Craigslist example, that’s the $5,000 he has to pay, regardless of whether the car is a clunker.
In real estate, closing costs, inspection fees, etc. are your up-front costs. You’re deciding to buy a new house, for which you must pay $2,000 in closing costs. You think there’s a 20% chance the house will gain $15,000 in value while you own it. There’s a 60% chance it will remain unchanged. And there’s a 20% chance it will lose $10,000 in value.
The expected profit on the house is 20% x $15,000 + 60% x 0 + 20% x ($–10,000) = $3,000 + $0 - $2,000 = $1,000.
At first glance, that looks like a positive expected value. But remember: No matter how it turns out, you always have to pay $2,000 in closing costs. So you subtract $2,000 from the expected profit, bringing the expected profit to -$1,000. This is a negative expected value transaction.
Use Positive Expected Value Consistently
Expected value decision-making isn’t a one-time thing. It’s a way of life. Expected values are based on probability. It only makes sense to use EV calculations if you use them consistently enough for the odds to even out. Making just a single decision based on EV doesn’t give you enough exposure to upside and downside outcomes for the odds to even out in your favor.
Don’t Die! Limit Your Bets
In order for you to make enough positive expected value decisions for the odds to work in your favor over time, you have to be able to stay in the game. That means being consicous of how much you can afford to lose.
Even if you always make only positive expected value bets, sometimes you’ll go through a dry spell where the odds just don’t work in your favor. You need to have enough of a cushion to make it through those times.
If you’re down to your last $1,000, making a $1,000 bet—even with a positive expected value—might not be wise. If you win, you clean up big. But if you lose, you’ve lost all the resources you have available to make other bets in the future. There’s no firm guideline as to how much of your remaining money to put into an uncertain decision, so you’ll have to use your judgment about how close to the edge you want to play.
This is one reason, by the way, that a rich person who thinks in terms of positive expected value can really clean up. They have the resources to make many positive expected value bets at once, so at any given moment, chances are that one or many of their projects are paying off.
Process, Not Outcome
As Billy Murphy puts it, contrary to how most of us think in business, outcomes don’t matter. Obesssing about success or failure isn’t useful. Obsessing about good processes in deciding where to put your time and energy is useful.
As long as you’re making positive expected value investments, you should expect some losses. But over the long term, you’ll win. Any one outcome isn’t as important as making decisions based on solid, simple math. Spend your time getting better at estimating outcomes and probabilities, make consistently positive expected value investments, and avoid risk of ruin, and you’ll find yourself on a steady path to greater and greater success.
Remember to check out my interview with expected value guru Billy Murphy at getitdoneguy.com/billymurphy.
I'm Stever Robbins. I help high achievers accelerate or change careers. If you want to know more, visit SteverRobbins.com.
Work Less, Do More, and have a Great Life!