Expected Value Thinking : How to make decisions in an uncertain world.
“Constantly thinking in expected value terms requires discipline and is somewhat unnatural. But the leading thinkers and practitioners from somewhat varied fields have converged on the same formula: focus not on the frequency of correctness, but on the magnitude of correctness.” – Michael Mauboussin
Making decisions in life always involves considering potential tradeoffs and opportunity costs. The challenge lies in navigating the complexity and confusion of the factors involved. It can be difficult to determine which statistics and factors are relevant and to think about averages.
Expected value is a powerful thinking tool that helps us to overcome these challenges. Although it may not come naturally to everyone, it enables us to weigh probabilities and outcomes and see the world in a more nuanced way. Once we master this approach, we can make more informed decisions. We become better equipped to assess risks, determine when to abandon a project, and identify when to take bold actions.
Expected value thinking is a way of thinking about the potential outcomes of a decision, taking into account both the probability and the possible outcomes. This approach involves multiplying the probability of each outcome by the value of that outcome, and then summing the products to determine the expected value of the decision.
For example, using expected value thinking, you would calculate the potential payoff of investing in the startup by multiplying the probability of success by the expected value of the success, and the probability of failure by the expected value of the failure (the loss incurred). This allows you to determine whether the overall expected value of the investment is positive or not and make an informed decision about whether to invest. Ofcourse individual results are not going to be 100% accurate but when you do this evaluation and invest in a lot of startups all with net positive expected value, the law of large numbers take over and you would end up with net profits. This is the model deployed by the biggest private equity funds or Angel investors. For instance, when they invest in 10 different startups, each with huge upsides but with high probabilities of failures, they already expect that 8 of those investments are not going to make them any money but they do believe that the 2 investments which do make money will make soo much value that it will more than offset their losses on the other startups. And so on an average they are going to generate profits. This is also an example of the pareto principle which says that on an average, 20% of your investments or actions contribute to 80% of the results.
Expected value calculations also need to take into account the potential for extreme variations from the average. Although averages can be helpful, they are not always sufficient. For example there is an old joke about a man who drowns in a river that has an average depth of three feet. The joke highlights the fact that when deciding whether to cross a river, the range of depths is much more important than the average depth, particularly if you can’t swim. In the case of investments, theres a saying of never putting all your eggs in a single basket, which essentially translates into never betting all your savings on a single investment. Because although the probability of that investment vehicle failing might be really low, in the off chance that it does fail, you lose everything you have and you lose the chance to play again.
Therefore whenever making predictions about the future, it is essential to consider the full range of potential outcomes. The greater the variability from the average, the more we must factor this into our decision-making process.
Large deviations can indicate greater risk, but this is not always a negative thing. Therefore, expected value calculations consider the possibility of deviations from the norm. By making decisions with a positive expected value and minimizing risk, we can open ourselves up to significant benefits.
By using expected value thinking, we can make more informed decisions by taking into account both the probability and the potential impact of each outcome, rather than just focusing on the probability of a particular outcome.
