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.