Expected Value Calculators: Knowing the Real Value of Opportunities and Time Spent.
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The Expected Value is the sum of all possible values for a random variable, each value multiplied by its probability of occurrence. It’s what poker players use to make betting decisions and it’s how the most successful investors and business people think.
Suppose you have $30,000 saved up and are debating between getting a job or starting an eCommerce store. You could simply evaluate the expected value of each.
The typical way someone approaches this might be: “If I get a job, I can make $50,000/year. If I start a store I could potentially make more, but it’s also risky.” They never specifically quantify the outcomes, leading to poor decisions.
Let’s apply some numbers. If you go out and get a job, you may make $50,000, but if you start a store, the expected value may be $95,000 based on industry averages of estimated earnings and the added value of the asset, because all profits of a business you own are worth a multiple. Unlike a job, a business has potentially unlimited upside and you control the variables.
If the store doesn’t work out, then you have $30,000 in living expenses which will still cover you for 15 months until you’d need to find a job. If the store starts to make money, that will buy you more time.
As soon as you quantify the outcomes, it changes the decision. Even if the expected value option doesn’t pan out, you can always go back to the job. The worst case scenario is you’ve acquired a valuable new skillset to put on your resume.
While no individual opportunity is guaranteed to pan out, systematically pursuing opportunities with a positive expected value means you’re going to find success over time.
This is key to understanding the sensibility of entrepreneurship as a career choice. While any individual business opportunity may fail, the systematic pursuit of opportunities that are positive expected value is more likely to pan out.
Scott Adams, the creator of the Dilbert comic, frequently cites over a dozen failed businesses he launched other than Dilbert, now one of the most widely syndicated comics in the world,
and one that’s made Adams worth over $75 million. While he’s had many failed ventures, the success of Dilbert more than compensates.
While the math behind EV has always been true, it’s now even more true because entrepreneurship is radically more accessible, the downside is dramatically lower, and potential upside is higher.
Dan Norris failed at 83% of the businesses that he launched in 2014, but the success of WP Curve more than made up for all those failures. Because the internet and technology have democratized product creation and distribution, you don’t have to invest tens of thousands of dollars or years of time on each opportunity. Instead of having to open a store on Main St., sign a lease for thousands of dollars, and pay thousands of dollars in advertising media, you can write posts on a blog (a few hundred dollars at most to set up a website) and then launch a new business in a week.
You also expect some outcomes to dwarf other outcomes. This is to be expected. Because the internet exposes entrepreneurs to potentially huge markets, there is more upside than ever before.
So, how can you get started using an expected value calculator to help your decision making?
How to Use an Expected Value Calculator
Tip: Download the free expected value calculator spreadsheet (below) for a free template to get started.
An expected value calculation consists of three steps:
Step 1: Brainstorm all the possible channels strategies – Be specific
- Put them in the power law expected value calculator. (You can download a copy of my spreadsheet below).
- Rank them based on the three criteria
- Do as many in the next 90 days as you have time and cash to execute on.
Step 2: Grade them on four criteria –
- How promising/likely to work is it?
- How excited am I about it?
- How much time will it take?
- How much cash will it take?
- How many customers are available?
Step 3: Test the top three.
In theory you want a channel that is:
1. highly likely to work,
2.that you are excited about, and
3. that will take very little time or cash and yield a lot of customers.
Repeat based on new data, and that’s really it.
Enter your email to get access to my free Expected Value Calculator tool to Improve your decisions and make them easier, more accurate and stress-free.
In his book, The 4-Hour Workweek, Tim Ferriss advocates the use of negative visualizations for people considering quitting their jobs. A tradition borrowed from Stoicism, negative visualization is the practice of imagining the worst possible outcome as a way to help ourselves make difficult decisions.
What the stoics unearthed and Ferriss rediscovered was this fundamental truth: we frequently avoid making choices not because the outcome is bad, but simply because it’s unknown.
Have you ever seen a cute guy or girl and wanted to go talk to them but stopped?
“Oh God, what will happen?”
Well, let’s say you go introduce yourself—what is the worst that can happen?
The worst thing that’s ever happened to me was: I had a girl look me up and down and laugh in my face. She laughed so hard, her spit actually hit me in the eye.
It stung. Physically because of the spit, metaphorically because of the rejection.
That pain lasted for about half an hour, and continued bothering me for a couple of weeks. Which sucks, but how bad is it really? Does it hurt? Yes, but it’s an emotional hurt. I’ve never seen that girl again, and no one thinks less of me because I was really bad at talking to girls when I was nineteen.
The hurt from that kind of interaction is something that humans evolved as a defense mechanism when we lived in small societies. If you lived in a tribe of fifty people and a girl rejects you, then it really did hurt. You had to see her every day. Your status was lowered in the tribe for the rest of your life; you might never find a mate, reproduce, and pass on your genes.
Loss Aversion and Expected Value
This principle is called loss aversion: when directly compared to each other, losses loom larger than gains.
Consider: You are offered a gamble on the toss of a coin. Heads, you win $150. Tails, you lose $100.
How do you feel about it? Although the expected value is obviously positive (if you repeated the bet 100 times, you’d almost certainly come out on top), most people decline the bet.
When asked, “What is the smallest gain that you need to balance an equal chance to lose $100?”, most people answer $200—twice as much as the loss. The ratio of loss aversion has been measured at between 1.5 and 2.5, meaning people typically want to see a 150–250% expected return to make the bet.
This, again, is a mentality from our evolutionary past.
If a bush rustles as you trot across the African savannah and there’s a 90% chance it’s a delicious meal and a 10% chance that it’s a hungry lion, you’re better off not investigating. You only have to be wrong once before your genes are out of the gene pool. In the modern world, in cases where death (or the career equivalent) is a real possibility, it’s still a good strategy.
However, that’s very rarely the case. A disproportionately large number of poker players end up becoming entrepreneurs.
Now I see why: they get the math.
When it comes to the way systems and probabilities work in the modern world, our intuition is poor to say the least.
Just as many amateurs see poker as a game of luck, many non-entrepreneurs see entrepreneurial success as luck. They think people that have prosperous businesses just got lucky and were “overnight successes.” They don’t see the years or decades of work, skill acquisition, and relationships that the entrepreneurs built up. They also typically haven’t been exposed to a simple, yet powerful concept: expected value.
Professional poker players are remarkably consistent in their earnings. What looks random from the amateur’s perspective is, from the professional’s angle, quite predictable.
It’s normal for poker players to lose a hand worth thousands of dollars, but be happy with how they played it. They understood what the probabilities were and bet accordingly.
Imagine that you’re playing a hand with one remaining card to be shown. You have to pay $1,000 to see the final card and stay in the hand. You know there is a 20% chance that it will be the card you need and you will win the entire hand worth $20,000.
If you pay $1,000, then you have a 20% chance to win $20,000. That is, you pay $1,000 for an expected value of $4,000 (20% × $20,000 = $4,000).
If it isn’t the card you need, that’s unfortunate. But, it doesn’t mean you shouldn’t have bet the way you did. If you were faced with that same situation one hundred times and bet the same each time, you would obviously invest. The large number of instances would make it all but certain that in sum, you would come out ahead. Paying $1000 to get $4000 is a straightforward proposition.