EV

In the world of trading, everybody has come in contact with the Expected Value formula; it's probably one of the most important. In this post, I want to talk about the EV formula in life in general and how obsessed you should be with it.

The formula

What you will gain * Probability of this happening + What you will lose * (1 - Probability of this happening) = EV

Example: You have a 40% probability of making €10 and losing €6 if it doesn't work.

(10 * 0.4) + (-6 * 0.6) = 0.4

This EV is really low, but if you were to play this game infinitely, you would win.

Now, how can you apply this to life? Another question would be, how do you quantify the qualitative? How do you estimate the probability of success in starting a unicorn company? Can you overestimate it? My approach is greatly influenced by Robert Rubin and his book, The Yellow Pad.

It all begins with asking the right questions. You have to note that getting the right numbers for this formula is more of an art than a science.

1. Try to search for quantifiable stats, so numbers that are already out there. For example, the probability of you starting a billion-dollar company. This is hard to estimate, but you can just google the odds based on people who have already tried it.
2. If it isn't already quantifiable, try to estimate it. What do you think is the cost for you to start a billion-dollar company? Let's just say $40,000 upfront. Then we need to also add some opportunity cost and so on. Like I said, it's more of an art than a science. Get creative.
3. In point 2, I already made a mistake. Take the risk as a range to appreciate the uncertainty and complexity that is involved. Saying $30,000 seems quite certain. Saying $20,000 to $200,000 is a bit different.
4. Try to look at the level of uncertainty you put around that judgment.
5. Consider if the tails of the distribution are thin or fat. What would happen if suddenly you lose your house and can't pay for your startup anymore?

You can start by just taking out a piece of paper or a Yellow Pad and brainstorming the probabilities and potential outcomes. By practicing, you will be able to do it in your head. You will feel pretty uncomfortable when doing this for the first time; humans are just not made to deal with uncertainty.

Let's try to do an example:

Starting a Unicorn:

Through a Google search, I can find out the probability of a startup becoming a unicorn. Some say 0.00006%, which would be 0.6 for every million startups. This seems like a good estimate. As of January 2024, there are over 1,200 unicorns around the world. With 50-100 million starting every new year, of course, many of them will fail in the first month. This would mean a chance of 0.0024%, which seems quite high. I could probably do a lot more research, but I will just keep it at that. So my range will be:

0.0024% - 0.000009%

The potential reward would be $1 billion or more in valuation.

The risk would be 1 - 0.0024% - 1 - 0.000009%.

The average investment into a startup in the first year is $40,000 of your own money, but I'm pretty sure you can also start with less. And of course, you will get funding if you have a solid idea. But for now, I'm talking about your own money. So let's put the range at $3,000 - $80,000.

Let's do the calculation:

Lower bound:

Let's say you are able to keep the cost really low. Even with the probability of being successful at the lower bound, your EV is still positive.

Now, if we were to jack up the cost to $80,000 for starting (the upper bound), it would not work.

So, if you are inexperienced or below average, you would want to keep the cost low to succeed and have a positive EV.

Average:

Let's say you think you are average from a skill perspective. This would allow you to keep the cost higher to succeed; the EV is still positive.

Upper bound:

Now, if you are a founder with a proven track record, you are able to have a higher cost to have a positive EV.

Now, I think the uncertainty around this is really high because the ranges and numbers are so big, as well as the tail risk involved. Overall, I think trying to start a startup has a good EV.

Note:

It's not only about looking at the reward but also about the risk, which is often forgotten. But it's also important, even if the odds seem favorable, to acknowledge the possibility of being wrong is crucial.

Uncertainty about events and their consequences is unavoidable. Even if the odds seem favorable, acknowledging the possibility of being wrong is crucial. You can try to practice this daily, and it's way easier on decisions with less uncertainty and which are more quantifiable.

Taking it to the extreme:

I also think you can take it to the extreme of doing EV calculations. One example is Sam Bankman-Fried, about whom I read in the book "Number Go Up." He calculated EV for everything. For example, the EV of cutting his hair wasn't sufficient enough.

Thanks,

Finn