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.
I read your post "The Million Dollar Question". It was very good. Thank you for sharing it. I can see myself in the friends you mentioned. I have these dreams of ways to increase my income. I have an internet side business that makes about $1500 a month. I know that there are many different ways I can scale it. In my mind I see the way, the things I need to do. But then I sit down to do those things and I freeze. I believe I am frozen by fear. I fear that if I do these things and they don't succeed, I have wasted my time. Or, I sit down and think of all the things I need to do to get to the endpoint and I think "that is a whole lot of work". So I don't do anything. I waste an hour reading HN and playing solitaire. It is really stupid.
Anyway, your post really made me think about it. I think I will write a plan of all the things I need to do to scale in one direction. Then I will break down the plan in small enough steps that can be accomplished in an hour or two. I'll write each step on a Post-It note. When I finish the step, I'll put it on the wall so I (and my wife) can see the progress. What do you think?
I think it's a good idea, and I empathize with where you're at. A few thoughts -
First, I think it can be helpful to start thinking in terms of expected value (EV) - I learned it from playing poker. If you play poker, you're often in a position where you make money on average by doing a good play, but you'll still lose a lot of the time. For instance, if you have an 80% chance of winning a hand and you get a big bet at you - of course you call. But 20% of the time you'll lose. Which sucks, but you've got to just shrug and not get upset because you did the right thing.
Expected Value is the Profit or Loss from a decision times the probably of that happening.
Box A has a 25% chance of giving you 30 dollars, a 50% chance of giving you 20 dollars, and a 25% chance of giving you 10 dollars. It costs 15 dollars to buy box A, what is your expected value?
30-15=15 ; 15 x .25= $3.75
20-15= 5 ; 5 x .5 = $2.50