MAKE BETTER DECISIONS TODAY!
By: J SCOTT
What separates good investors from bad investors? More than anything, it’s the ability to make good decisions.
And honestly, I don’t fault most investors for not making better decisions. Many investors aren’t familiar with all the tools available to help them make optimal decisions.
So, today I wanted to introduce you to a decision making tool that can be applied not only to many of your investing decisions, but also to a wide variety of decisions most people make in their daily lives.
It’s called Expected Value.
WHAT IS EXPECTED VALUE?
Expected value is a tool that can help you make optimal decisions in situations that you are likely to encounter multiple – perhaps even dozens or hundreds – times. While it may not help you decide if you should take that once-in-a-lifetime vacation to France or to Italy, or to help you decide if you should say yes to your significant other’s marriage proposal, it can help you decide whether you’re more likely to generate a higher profit by focusing on investing in one type of deal versus another.
In other words, it’s great for those decisions that you’ll find yourself making over and over, and where you can judge the likelihood—and the financial result—of each potential outcome.
Expected value is simply the long-term average result you should expect when you make the same financial decision over and over.
AN EV EXAMPLE
As a very simple example, let’s say that we were to offer you a betting game that you can play as many times as you’d like.
We roll a six-sided die, and you guess which number it will land on. If you guess correctly, you win $10. If you guess incorrectly, you lose nothing. However, it will cost you $2 each time you play the game.
Should you play this game?
We know that if you don’t play the game, you have no financial gain or loss. The question is, if you do play the game, can you expect to win more than $0? We can use EV to answer this question.
The EV formula considers each possible outcome from the game and multiplies the likelihood of each outcome by the financial gain or loss.
In our game example, there are two possible outcomes:
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You pay $2 to play the game, you guess the correct number, and you win $10. Your total financial gain in this scenario is $8 ($10 in winnings minus $2 to play the game).
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You pay $2 to play the game, you guess the incorrect number, and you win nothing. Your total financial loss in this scenario is $2 (the $2 to play the game).
In addition to determining all the possible outcomes, we also need to determine the probability of each occurring.
In this case, the likelihood of Scenario No. 1 occurring is 1 out of 6 (there are six sides to the die, and each has an equal chance of being rolled). That’s about 16.7 percent. The likelihood of Scenario No. 2 occurring is 5 out of 6, or about 83.3 percent.
Here's a visual representation of the potential outcomes and their probabilities:
To determine the EV of each play of the game, we multiply the financial result of each potential outcome by the likelihood of that result occurring, and then add them all up.
EV = ($8 × 16.7%) + (-$2 × 83.3%)
EV = $1.34 – $1.67
EV = -$0.33
The expected value of this game is negative $0.33. That means for each time you play this game, you can—on average—expect to lose $0.33.
Now, that doesn’t mean you’ll lose $0.33 each time you play. In fact, you never will. Each time you play, you’ll either earn $8 or lose $2. But, if you play this game enough times, your average result will be a $0.33 loss. If you play 1,000 times, you can expect to lose about $330 (1,000 × $0.33).
The logical decision is that your best financial interest is not to play this game.
As you can see, EV is great tool because it takes a decision that can feel like a simple matter of opinion (whether to play the game) and turns it into a quantifiable decision (you will lose money if you repeatedly play this game).
REAL ESTATE EXAMPLE
Now, let’s look at how Expected Value can be applied to a real estate investing decision. Let's take a look at a situation many of us are facing these days: should we be investing in lower risk investments that generate lower, but safer, returns or higher risk investments that have more potential upside, but also more potential downside?
In order to apply EV to this type of question, we again need to determine two things: the list of potential financial outcomes associated with each option and the likelihood of each of those outcomes.
Let’s start with what a typical low risk real estate investment might look like these days -- for this example, let's go with making a $100,000 hard money loan for a single family deal for three years. You can apply any assumptions you want, but here's what I would expect the likely outcomes for a hard money loan to be these days:
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Earn an average return of about 12% per year (80% probability of this happening)
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Have the deal not perform, receive your capital back but make no profit (10% probability)
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Have the deal go south and lose 50% of your capital (10% probability)
In other words, I would expect that 80% of the time everything would go well and we'd make about 12% annual return on the investment. 10% of the time things wouldn't go well, but we'd figure out a way to recover our initial investment. And 10% of the time things would go very poorly and we'd lose half of our investment.
Our other alternative is a higher risk investment. For this example, let's say we're considering investing $100,000 into a single family development project over the next three years. For the sake of this article, let's assume the likely outcomes of this investment are as follows:
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Earn an average return of about 22% per year (50% probability of this happening)
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Have the deal under-perform, receive average return of 10% per year (10% probability)
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Have the deal over-perform, receive average return of 30% per year (10% probability)
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Have the deal not perform, receive your capital back but make no profit (10% probability)
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Have the deal go south and lose 100% of your capital (20% probability)
Again, I'm making up these scenarios and probability based on my experience with these types of deals, but you may have better or more accurate scenarios and probabilities based on your knowledge of a particular deal.
Here's a visual representation of the potential outcomes and their probabilities:
To determine the EV of each play of the game, we multiply the financial result of each potential outcome by the likelihood of that result occurring, and then add them all up.
For the hard money lending scenarios:
EV = ($36,000 × 80%) + ($0 × 10%) + (-$50,000 × 10%)
EV = $28,800 + $0 - $5,000
EV = $23,800
For the new construction investment scenarios:
EV = ($66,000 × 50%) + ($36,000 × 10%) + ($90,000 × 10%) + ($0 × 15%)+ (-$100,000 × 15%)
EV = $33,000 + $3,600 + $9,000 + 0 - $15,000
EV = $30,600
Assuming we're comfortable with our assumptions about the potential scenarios and their likelihoods (and again, I'm just making up these scenarios for this article), it would appear that over many similar investments, investing in single family development project is going to be more profitable than investing in hard money lending.
Keep in mind that this only answers the question of what the optimal financial decision is -- it doesn't take into account other aspects of the decision. For example, while the new construction investment might have a higher average return, it also has a much higher risk of losing all of your investment. If your risk tolerance is low, you may be better off with the lower risk investment that returns less.
