We make decisions in a world filled with risks. Will my boss like and approve my project idea? Will my customers appreciate and purchase my product? Will my community support and fund my program? Because the world is risky, sometimes things don’t go our way. When that happens we are inclined to feel sad, disappointed, and frustrated. And since we usually don’t like feeling this way we tend to be risk averse, meaning we prefer to avoid risky situations.
It’s easy to explain risk aversion, and how it relates to expected value, with a quick example. Suppose I give you a choice between two situations, one with a guaranteed payment and one where the payment depends on the outcome of a gamble. In the guaranteed situation, I simply give you $50. In the uncertain situation, I flip a coin and if the coin lands on heads I give you $100. If the coin lands on tails you receive nothing. The expected value of this gamble is 0.50 * $100 + 0.5 * $0 = $50, so the expected value of both situations is $50. If you make decisions based on expected value, meaning you are risk neutral or indifferent to risk, then you wouldn’t care which situation you chose. You’d probably flip a coin to decide which situation to choose.
However, most of us don’t feel this way about gambles and uncertainty. We prefer certainty to uncertainty, so we’re willing to give up part of the payment for additional certainty. You can gauge whether you are risk averse by considering the preceding example and asking yourself whether you would be willing to accept some amount less than fifty dollars, perhaps $35 or $40, with certainty rather than take the gamble and risk receiving nothing. If so, welcome to life outside casinos.
Since people are usually averse to risk, it is important for you to incorporate this attitude into decision trees you use to aid your decision making. If you don’t, if instead you use expected values in the decision tree, then you’re (implicitly) assuming you’re risk neutral and you’re making decisions that do not appropriately reflect your attitude toward risk. Doing so can lead you to make the wrong decisions, decisions that aren’t in your best interest based on your risk preferences.
Given how important it is for you to know how to incorporate these preferences into decision trees, I will show you how to do so in a future article. Until then, take some time and think about some of the decisions you’re frequently called on to make. Can you draw decision trees that represent your decision situations? Do you consider the risks involved and your attitudes toward these risks? If the potential outcomes of your decisions are important to you, then you need to spend the time to structure and sketch the decision situation and consider your attitude toward the risks involved. By giving form to your decision situation you will straighten out your thinking, you may even discover key factors or alternatives you hadn’t thought of yet, and by considering your attitude toward the risks involved you’ll ensure your decision appropriately reflects your risk preferences. When the potential outcomes are important enough, be sure to consider these techniques before making your decision. You’ll feel a lot better about your decision if you do.