I went over my managerial accounting homework yesterday and discovered something interesting. The problem was a standard expected value problem in which given 3 choices with multiple possibilities, we were to decide which choice was optimal.
After calculations there were 3 options: choice A had an EV (expected value) of 20k, choice B’s EV was -4k and choice C’s EV was 14k.
What shocked me was that although the answer A was correct, the solution still recommended option C because it had the lowest coefficient of variation (the lowest risk per dollar invested).
I thought about this for a minute. Why do we care about risk? Isn’t EV just EV, period? Why would I choose anything with lower EV?
I thought about my past involvements with risk/reward scenarios such as poker or fantasy football and came to the conclusion that humans, (especially myself), are inherently bad at understanding risk. I think this is because of the limited amount of time we are given. Risk is a negative factor because we are given a set amount of time and we literally don’t have enough time to see the risks play out. After all, we only have 16 games of fantasy football before a champion is determined that season.
This is especially true if a person is just beginning a risk oriented venture such as playing poker. A veteran can make all-in bluffs 3 times in a row if he knew it was the right play, but this can hurt the developing player.
What’s important for development is to string a series of small wins and see a positive cash flow. That’s because we don’t manage and track EV we manage and track successes and failures. Emotionally, we beat ourselves up when we lose and we pat ourselves on the back when we win.
In my opinion, time and experience are the two main factors to risk. If you have time on your hands and can think long term, go for the highest EV, otherwise, pick the option most likely to succeed.
Or, you can go all out and track the EV of all your decisions, but that would be close to impossible (although I’d love to see someone actually do that).
If you want to learn how to calculate EV and Coefficient of Variation click here.
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