Are you taking enough risks?

Today’s episode is on decision-making in uncertainty. It may be the most important episode I’ve ever written (and I’ve written more than 300 of them!). It gets a bit technical, but it’s worth taking the time to understand it. Master this technique and it can change the course of your life for the better.

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One of my favorite classes in business school was enterpreneurship. The professor asked us on the last day of class: Are you taking enough risks? Playing it too safe is a guaranteed way to get nowhere in life.

I’ve thought about this question a lot during my career. My answer is almost always “No.” But I’ve never known which risks to take, and which risks would be…well, too risky.

I can pinpoint 4 decisions in my life that were the wrong decisions. The very wrong decisions! Yet no matter how many times I’ve reviewed them, given the information available at the time, I’d do the same thing again. Luck played a big factor in the actual outcomes, and there was no obvious way to account for that in the decision-making process.

No obvious way until recently, until I met Billy Murphy of ForeverJobless.com

A 29-year-old former professional poker player, turned entrepreneur, Billy wrote an article that gave me the missing piece. In one reading, he changed how I think about decision-making forever. I’ve recorded an interview with Billy billy-murphy-discusses-better-decisions-with-expected-value. Be sure to check it out.

The tool he presents is something I learned in my first semester of business school, in the module on decision-making under uncertainty, back before those sucky decisions. But business school never taught when and how to use the tool; they just presented it as an isolated technique. It’s called “expected value.” Now that I understand how to use it, I wish I could replay the last 20 years of my life. In all 4 of my bad decisions, expected value is the missing piece that would have led me to make what ultimately would have been better decisions.

Cost/Benefit Analysis Doesn’t Work Well

We’re trained to evaluate a decision by looking at the costs and the benefits. Or maybe we do a worst case, expected case, and best case. Either way, we compare outcomes and choose what feels like the best path.

But this is a poor way to make decisions. First, we put far more emotional weight on avoiding loss than we do on gaining benefits, so we let the worst case overwhelm our thinking. And then there’s luck. Not all outcomes, costs, benefits, and cases are equally probable. Luck plays a big role, and humans are horrible at reasoning about luck.

Expected value gives a way to include the missing piece—the probability of each alternative—in our decision making.

Expected Value encourages calculated risks when it makes sense.

The expected value of a decision is the decision’s outcome multiplied by the probability of that decision. For example, imagine you have a rigged coin that flips heads 30% of the time, and tails 70% of the time. If it comes up heads, you get $100. If it comes up tails, you get nothing. The expected value of the coin flip is 30% times $100 or $30. If you take this bet 100 times in a row, over time, you’ll make about $3,000—roughly $30 per toss.

Both outcomes can have payoffs attached. Let’s change the game a bit. If heads pays $100 and tails pays $20, then the expected value is $100 x 30% plus $20 x 70%, or $30 plus $14 or $44. Under those terms, if you took the bet 100 times, you’d make around $4,400 or roughly $37 per toss.

See also: Is There a Difference Between Odds and Probability?

The expected value of a decision is the sum of all the possible outcomes, with each outcome being multiplied by the probability of that outcome coming to pass.

Make Positive Expected Value Decisions

On the surface, it may seem like expected value only applies to cases where you make the same decision over and over. If you can flip the coin 100 times, then it makes sense to think in terms of expected value. But if you can only flip it once, you’ll make either $100 or $20; you won’t make $44. So expected value isn’t much use there, right? Wrong!

If you consistently calculate the expected value of each decision you make, any individual decision may work out or may not. But if you always decide to pursue options that have a positive expected value, over time, luck will work in your favor enough that you’ll get some real payoffs.

Do I Stay or Do I Go?

I’ve had coaching clients work with me on whether they should quit their job to start their own company. Should they leave a guaranteed $80,000 per year job to start something entrepreneurial? Let’s look at the expected value calculation.

A ballpark estimate is that starting their own company would give them a 10% chance of eventually making $500,000 per year, a 40% chance of making $100,000 per year, and a 50% chance of going bankrupt and making nothing. Personally, the 50% bankruptcy possibility would scare me into staying. But wait…

The expected value of staying at the job is 100% times $80,000 per year, or $80,000.

The expected value of my client starting their own company is 10% x $500,000 plus 40% x $100,000 plus 50% x 0． That’s $50,000 plus $40,000 or $90,000, compared to the $80,000 expected value for staying. The highest expected value choice is for him to quit and start his own company (even though the risk of failure is 50%)!

(Just for the record, he made over $100 million in his first 5 years and is probably going to be a billionaire by the time he’s 50.)

That’s where expected value makes the difference. It encourages taking calculated risks when the payoff is high enough and probable enough to make sense. A lifetime of positive expected value choices leads to more rolls of the dice, and enough big wins to offset the losses.

When you’re faced with a financial choice (or any kind of choice, really), don’t just think worst-case/best-case. Estimate probabilities and calculate the expected value of the decision. Pursue choices with the highest expected value. You will have plenty of losses and plenty of wins, but consistent positive-expected-value decision making will eventually pay off.

In Part 2 of this episode, we’ll delve into expected value in more detail. Remember to check out the interview with Billy Murphy at getitdoneguy billymurphy.

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!