I was talking with another investor recently and used a term I assumed he would be familiar with. He wasn\u2019t, which led me to realize that a simple but very effective tool for decision-making was likely to be overlooked by many others as well.<\/span><\/p>\n The tool\/concept is called expected value (EV), and I\u2019m most familiar with this concept because I spent my youth playing way too much high-stakes poker.\u00a0<\/span><\/p>\n In poker, EV is one of the most common tools used to determine an optimal decision (fold, call, raise, etc.) in the middle of a hand, especially in big situations where all the chips are on the line.<\/span><\/p>\n But, EV can be applied to a wide range of decisions, including decisions related to our investments.\u00a0<\/span><\/p>\n Let\u2019s look at how EV works, using a straightforward example from the poker world.<\/span><\/p>\n We\u2019re sitting in a poker game. It\u2019s the end of the hand, and there\u2019s $400 in the pot, and the other player in the hand bets $100, making the pot $500, requiring you to put in $100 to see a show-down.<\/span><\/p>\n You have a decision to make: Do you call the $100 bet or not?<\/span><\/p>\n While I could give you all the details of the hand\u2014what cards you have, how the betting played out, whether the other player looks nervous. The only piece of information you need to make an optimal decision about whether to call is what you estimate the likelihood of you having the best hand (and therefore winning the pot).<\/span><\/p>\n To determine the expected value for a decision, you multiply the probability of each possible outcome by the value of that outcome and then add up the results.<\/span><\/p>\n In this case, there are three possible outcomes:<\/span><\/p>\n Let\u2019s say that you believe there\u2019s a 25% chance that you have the best hand and a 75% chance of having the worst hand. In other words, you will most likely lose, regardless of what you do.\u00a0<\/span><\/p>\n But what about the expected value?<\/span><\/p>\n There\u2019s a 25% chance of the first scenario above happening (you having the best hand and win), and if it does, you\u2019ll win $500 (the amount in the pot). There\u2019s a 75% chance of the second scenario happening (you have the worst hand and lose), and if it does, you\u2019ll lose $100 (the amount you need to spend to call the bet).<\/span><\/p>\n To determine the EV, we multiply the probability by the outcome for each scenario and add them up:<\/span><\/p>\n EV = (25% * $500) + (75% * -$100)<\/span><\/p>\n EV = ($125) + (-$75)<\/span><\/p>\n EV = $50<\/span><\/p>\n The Expected Value is $50. What does this mean?<\/span><\/p>\n It means that, while we have no idea if we\u2019ll win $500 or lose $100 this hand, if we were to play out this exact situation a million times, we should expect to win, on average, $50 per situation.<\/span><\/p>\n A good poker player knows that while there is a 75% chance of losing this hand and going broke. Over the long term, taking that risk every time it comes up will ultimately make money.\u00a0<\/span><\/p>\n In fact, if a poker player finds themselves in this exact situation 100 times, they should expect to earn 100 * $50 = $5,000 across all these situations.<\/span><\/p>\n A positive expected value investment\/decision is one that you should always consider making. A negative EV investment\/decision is one that you should always consider passing on.\u00a0<\/span><\/p>\n Had the expected value for the poker situation above been negative, a fold would have been the right move.<\/span><\/p>\n We can apply the same logic to other types of decisions and different types of investments.<\/span><\/p>\n For example, it\u2019s typical for house flippers who do a high volume of deals to consider \u201cself-insuring\u201d their properties. This means they don\u2019t get insurance for the flips and assume the risk\/cost themselves.<\/span><\/p>\n But is it smart to self-insure your flips? Let\u2019s make some assumptions and run an EV equation.<\/span><\/p>\n Let\u2019s assume:<\/span><\/p>\n Should we pay the $1,000 in insurance for each of our flips? Or self-insure?<\/span><\/p>\n Let\u2019s take a look at the EV for self-insuring. We\u2019ll start with the possible outcomes and the value of each:<\/span><\/p>\n EV = (97.5% * $0) + (2% * $10,000) + (.5% * $100,000)<\/span><\/p>\n EV = $0 + $200 + $500\u00a0<\/span><\/p>\n EV = $700<\/span><\/p>\n The EV on self-insuring is $700. That means, on average, we\u2019d spend $700 per project paying for things that would have otherwise been covered by insurance.<\/span><\/p>\n In other words, if we were to do 100 flips, we could expect that we\u2019d save about $300 per flip by self-insuring. Or $30,000 across all 100 flips!\u00a0<\/span><\/p>\n While this is highly simplified, and you\u2019ll have to use the numbers that make sense for your flips (both insurance costs and likely claims), you can see why many house flippers who are doing large volumes of flips choose to self-insure.<\/span><\/p>\n There are thousands of scenarios you\u2019ll run into, both with your investments and daily life, where expected value calculations allow you to make much better decisions than just \u201cgoing with your gut\u201d.<\/span><\/p>\n Modify your investing tactics\u2014not only to survive an economic downturn, but to also thrive! Take any recession in stride and never be intimidated by a market shift again with Recession-Proof Real Estate Investing<\/a><\/em>.<\/p>\n<\/div>\n<\/div>\n<\/div>\nHow Does Expected Value Work?<\/span><\/h2>\n
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How Expected Value Applies to Other Investment Decisions<\/span><\/h2>\n
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Final Thoughts<\/span><\/h2>\n
Disclaimers about expected value<\/span><\/h3>\n
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![\"recession](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2021\/04\/recession-proof-1.png\" "\\"Expected")
<\/source><\/source><\/picture><\/figure>\nPrepare for a market shift<\/h3>\n