In this episode we talk about a formula to help you make hard decisions in a quantitative way.
Making decisions is hard. And how do you know if you're making the right decision? When I was younger, I remember the decision making process was totally alien to me, and it was something I had a very tough time doing because decision making there is a science to it. But there's also an art to it as well.
When you are decision making, part of your decision comes from objective factors, and the other part comes from subjective factors. The subject of factors is the art part. This is where you just have to figure out what you value and assign some kind of point system to that value to make it quantitative. Quantitative means you're using numbers for your decision. So today we're going to cover the expected value formula, and this formula is going to help you make decisions in a quantitative way.
We're actually gonna use math to be able to make our decisions. And the way the expected value formula works is you take the probability of all your winds minus the probability of all your losses. Let me back up a little bit. You take the some of your winds and the sum of your losses multiplied by each probability to get your expected value, and that's probably confusing as well.
So I'm going to repeat it one more time. You take the probability of all the sum of all your winds, and you take the and you subtract the probability of the sum of all your losses to get your expected value. So let's use an actual example case so we can internalize this and it makes sense in our head.
Let's say that we have $20,000 to invest and we're making an investment decision. Let's say this investment decision is for a car. We're going out and we're looking for Shelby Cobra's, and we know that 10% of the time when you buy a Shelby Cobra, that Shelby Cobra is going to be worth $100,000. However, there are a lot of lemons out there as well. So 90% of the time that you buy Shelby Cobra, that Shelby Cobra, where it will be worth $0. So what is the expected value if you were to buy a Shelby Cobra? If you take 10% of the $100,000 the 10% probability that you will win $100,000. That's $10,000 than 90% probability that you'll win $0. Well, that's $0 so you have an expected value of $10,000. Now, let's say that the person that was selling you, the Shelby Cobra, he wanted $20,000 for it. If you have an expected value of $10,000 and this person wants $20,000 for this investment, then you are going to lose $10. Because if you pay $20,000 and your expected value is only $10 you're in the whole $10. So that is not a good decision. Let's flip it and let's say that you still have the $20,000 investment and you're holding onto the $20,000. But let's say that for I don't know, a white Lamborghini Kentish. Let's say that 90% of the time when you buy a white Lamborghini contacts, that car is going to be worth $100. These are incredibly rare, and they are likely not lemons. These have been well maintained, and this is like the figures you're getting from the market. So 90% of the time you buy a white Lamborghini coming Tosh is going to be $100,000.10 percent 10% of the time. It's gonna be $0 so 90% times 100,000 is $90,000 minus 10% time zero, which is zero. So the expected value is $90,000. And if the person that was selling the car he just wanted your $20,000 and you were going to take on this risk, would that be a good decision? And hell, yeah, it would be a good decision because you have an expected value of $90,000 your investments only $20,000 which means you are going to be in the money by $70,000.
So you look at the probability of all your winds and you subtract the probability of all your losses to get your expected value, and that will give you a base ground for your investment decision making. If your expected value is higher than what the cost is to get into that investment, you are in the money. But if the expected value is lower than what the cost is, you could be losing money. I hope that helps your decision making ability. There are several different ways to make decisions as well, but this one it uses a mix of subjective and objective reasoning to come up with this investment decision. Hope that helps and we will cover more decision making pot or more decision making material in upcoming podcast. Boom. Bam. I'm out.
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