Parking Tickets

An example of expected value is parking tickets. Let’s say that a parking spot costs $5 and the fine for
not paying is $10. If you can expect to be caught one-third of the time, why pay for parking? The
expected value of doing so is negative. It’s a disincentive. You can park without paying three times and
pay only $10 in fines, instead of paying $15 for three parking spots. But if the fine is $100, the
probability of getting caught would have to be higher than one in twenty for it to be worthwhile. This is
why fines tend to seem excessive. They cover the people who are not caught while giving an incentive
for everyone to pay.
Consider speeding tickets. Here, the expected value can be more abstract, encompassing different
factors. If speeding on the way to work saves 15 minutes, then a monthly $100 fine might seem
worthwhile to some people. For most of us, though, a weekly fine would mean that speeding has a
negative expected value. Add in other disincentives (such as the loss of your driver’s license), and
speeding is not worth it. So the calculation is not just financial; it takes into account other tradeoffs as
well.
The same goes for free samples and trial periods on subscription services. Many companies (such as
Graze, Blue Apron, and Amazon Prime) offer generous free trials. How can they afford to do this?
Again, it comes down to expected value. The companies know how much the free trials cost them.
They also know the probability of someone’s paying afterwards and the lifetime value of a customer.
Basic math reveals why free trials are profitable. Say that a free trial costs the company $10 per person,
and one in ten people then sign up for the paid service, going on to generate $150 in profits. The
expected value is positive. If only one in twenty people sign up, the company needs to find a cheaper
free trial or scrap it.
Similarly, expected value applies to services that offer a free “lite” version (such as Buffer and
Spotify). Doing so costs them a small amount or even nothing. Yet it increases the chance of someone’s
deciding to pay for the premium version. For the expected value to be positive, the combined cost of
the people who never upgrade needs to be lower than the profit from the people who do pay.
Lottery tickets prove useless when viewed through the lens of expected value. If a ticket costs $1 and
there is a possibility of winning $500,000, it might seem as if the expected value of the ticket is
positive. But it is almost always negative. If one million people purchase a ticket, the expected value is
$0.50. That difference is the profit that lottery companies make. Only on sporadic occasions is the
expected value positive, even though the probability of winning remains minuscule.
Failing to understand expected value is a common logical fallacy. Getting a grasp of it can help us to
overcome many limitations and cognitive biases.

Expected Value and Poker

Let’s look at poker. How do professional poker players manage to win large sums of money and hold
impressive track records? Well, we can be certain that the answer isn’t all luck, although there is some
of that involved.
Professional players rely on mathematical mental models that create order among random variables.
Although these models are basic, it takes extensive experience to create the fingerspitzengefühl
(“fingertips feeling,” or instinct) necessary to use them.
A player needs to make correct calculations every minute of a game with an automaton-like mindset.
Emotions and distractions can corrupt the accuracy of the raw math.
In a game of poker, the expected value is the average return on each dollar invested in the pot. Each
time a player makes a bet or call, they are taking into account the probability of making more money
than they invest. If a player is risking $100, with a 1 in 5 probability of success, the pot must contain at
least $500 for the bet to be safe. The expected value per call is at least equal to the amount the player
stands to lose. If the pot contains $300 and the probability is 1 in 5, the expected value is negative. The
idea is that even if this tactic is unsuccessful at times, in the long run, the player will profit.
Expected-value analysis gives players a clear idea of probabilistic payoffs. Successful poker players
can win millions one week, then make nothing or lose money the next, depending on the probability of
winning. Even the best possible hands can lose due to simple probability. With each move, players also
need to use Bayesian updating to adapt their calculations. because sticking with a prior figure could
prove disastrous. Casinos make their fortunes from people who bet on situations with a negative
expected value.

The Use of Expected Value: How to Make Decisions in an

Uncertain World
Thinking in terms of expected value requires discipline and practice. And yet, the top performers in
almost any field think in terms of probabilities. While this isn’t natural for most of us, once you
implement the discipline of the process, you’ll see the quality of your thinking and decisions improve.
In poker, players can predict the likelihood of a particular outcome. In the vast majority of cases, we
cannot predict the future with anything approaching accuracy. So what use is the expected value
outside gambling? It turns out, quite a lot. Recognizing how expected value works puts any of us at an
advantage. We can mentally leap through various scenarios and understand how they affect outcomes.
Expected value takes into account wild deviations. Averages are useful, but they have limits, as the man
who tried to cross the river discovered. When making predictions about the future, we need to consider
the range of outcomes. The greater the possible variance from the average, the more our decisions
should account for a wider range of outcomes.
There’s a saying in the design world: when you design for the average, you design for no one. Large
deviations can mean more risk-which is not always a bad thing. So expected-value calculations take
into account the deviations. If we can make decisions with a positive expected value and the lowest
possible risk, we are open to large benefits.
Investors use expected value to make decisions. Choices with a positive expected value and minimal
risk of losing money are wise. Even if some losses occur, the net gain should be positive over time. In
investing, unlike in poker, the potential losses and gains cannot be calculated in exact terms. Expected-
value analysis reveals opportunities that people who just use probabilistic thinking often miss. A trade
with a low probability of success can still carry a high expected value. That’s why it is crucial to have a
large number of robust mental models. As useful as probabilistic thinking can be, it has far more utility
when combined with expected value.
Understanding expected value is also an effective way to overcome the sunk costs fallacy. Many of our
decisions are based on non-recoverable past investments of time, money, or resources. These
investments are irrelevant; we can’t recover them, so we shouldn’t factor them into new decisions.
Sunk costs push us toward situations with a negative expected value. For example, consider a company
that has invested considerable time and money in the development of a new product. As the launch date
nears, they receive irrefutable evidence that the product will be a failure. Perhaps research shows that
customers are disinterested, or a competitor launches a similar, better product. The sunk costs fallacy
would lead them to release their product anyway. Even if they take a loss. Even if it damages their
reputation. After all, why waste the money they spent developing the product? Here’s why: Because the
product has a negative expected value, which will only worsen their losses. An escalation of
commitment will only increase sunk costs.
When we try to justify a prior expense, calculating the expected value can prevent us from worsening
the situation. The sunk costs fallacy robs us of our most precious resource: time. Each day we are faced
with the choice between continuing and quitting numerous endeavors. Expected-value analysis reveals
where we should continue, and where we should cut our losses and move on to a better use of time and
resources. It’s an efficient way to work smarter, and not engage in unnecessary projects.
Thinking in terms of expected value will make you feel awkward when you first try it. That’s the
hardest thing about it; you need to practice it a while before it becomes second nature. Once you get the
hang of it, you’ll see that it’s valuable in almost every decision. That’s why the most rational people in
the world constantly think about expected value. They’ve uncovered the key insight that the magnitude
of correctness matters more than its frequency. And yet, human nature is such that we’re happier when
we’re frequently right.