If we flipped a coin and offered the following payouts:
Everytime it was heads you would earn $2.
Everytime it was tails you would lose $1.
A rational person would be expected to always agree to that deal.
But, if I offered the same deal, and instead of $2 and $1, it was $200,000 and $100,000, you might think twice. Why?
Because the question isn’t whether benefit outweighs risk. It’s how much you’re willing to risk.
That’s the case when the chances of success are 50/50. In fact, most of life’s opportunities are binary—but that doesn’t make them 50/50 gambles.
If you can learn to assess opportunities and their expected value in terms of their real probabilities of success, it becomes possible to only enter into decisions with positive expected value while avoiding those that offer negative expected value.
Shrewd investors engage in this line of thinking. Take an investor who allocates for a biotech company’s untested new drug. Even if they’ve calculated the probability of the drug’s success to be 50/50, success in this case could lead to a payout far greater than 2x their investment.
This means there is a big mathematical advantage to taking the risk, because you are potentially rewarded more than you stand to lose, for a 50/50 outcome.
These gradients of probability and reward are the ways shrewd investors maximize expected value for a given amount of risk.
Here is a simple example of the math at work.
Suppose you invested $100 in a basket of 10 Internet company stocks in 1995. Now suppose that over the next 15 years, 9 of them went to $0, but one of them went to $2000. You would have seen a substantial return, because even though you lost 100% in 9 of your holdings, you gained 2000% in one of them.
Let’s be overly simplistic and suggest cryptocurrency as a technology has a 50% chance of succeeding and 50% chance of failing. If it fails, an investor has lost their investment.
If instead, it succeeds, an investor holding a diversified basket of cryptocurrencies would increase the likelihood of owning one of the long-term Apples or Amazons of this blockchain technology space.
In addition, note that the cryptocurrency industry is not correlated with the movement of the stock market, and therefore actually reduces overall portfolio volatility.
The point: Math is a common-sense tool not reserved for the elite. Binary events with unequal probabilities or payouts should be taken advantage of by rich and poor alike. The question isn’t ‘if’; it is instead ‘how much.’
People who understand these mathematical principles of expected value took advantage of a diversified portfolio of Internet stocks and saw great success. The same logic will apply with blockchain technology and its cryptocurrency applications.
Most importantly, this logic can ensure that each and every decision we make will result in an incrementally happier and richer life.